The wrong way to think about moral hazard
I am continually amazed at the amount of nonsense that I’ve been reading on the subject of moral hazard. Here are a few examples:
1. Moral hazard played no role with SVB because the shareholders and bondholders were wiped out. (nonsense)
2. Moral hazard isn’t an issue because average people don’t think about the safety of a bank when making deposits. (nonsense)
3. Moral hazard isn’t an issue because average people are unable to evaluate the risk of various banks. (wrong)
4. A run on bank deposits could cause a recession. (wrong)
If you see anyone making the first two arguments above, just stop reading. They literally do not know what moral hazard is. The fact that a business failed and the owners lost everything has no bearing on the issue of moral hazard. Here’s Matt Levine:
Schematically, a bank consists of shareholders taking $10 of their own money and $90 of depositors’ money and making some bets (home loans, business loans, bond investments, whatever) with that combined pile of money. If the bets pay off, the shareholders get the upside (the depositors just get their deposits back). If the bets lose, the shareholders lose money (the depositors get their money back before shareholders get anything). If the bets lose really big — if the bank bets $100 and ends up with $50 — then the shareholders lose all their money, but the depositors get their money back: If the bank is left with only $50, the government gives the depositors the other $40.
If you are a rational bank shareholder (or, more to the point, a bank executive who owns shares and gets paid for increasing shareholder value), this structure encourages you to take risk. If you bet $100 on a coin flip and you win, the bank has $200, and the shareholders keep $110 of that, a 1,000% return. If you lose, the bank has $0, and the shareholders lose $10 of that, a -100% return. The expected value of this bet, for the shareholders, is positive. The expected value for the depositors is neutral: Either way they get their $90 back, either from the bank or from the government. The expected value for the government is negative: If the bank wins, the government gets nothing; if the bank loses, the government pays the depositors $90. But the shareholders — really the executives — are the ones who get to decide what bets to take.
Deposit insurance gives bank executive an incentive to take socially excessive risks. In some cases the risks won’t pay off. But that doesn’t mean executives don’t have an incentive to take excessive risks.
Things didn’t pan out for SVB. But that doesn’t mean their executives made an unwise gamble. It’s very possible that SVB’s strategy had a very high expected payoff, and they were simply hit by bad luck (rising interest rates.) Of course from a social perspective their decisions may have been bad, but not necessarily from a private perspective. “Heads I win, tails part of my losses are borne by taxpayers”. Of course I’d take more risk with those odds.
And yet despite this clear explanation of how moral hazard works, Matt Levine follows a description of how SVB went bankrupt with this head scratcher:
And so the question is: Is that moral hazard? Well, not for shareholders and executives and bondholders.
No! The fact that things didn’t work out for the executives doesn’t have any bearing on the question of whether moral hazard distorted decision-making at SVB.
The second misconception above also illustrates a basic lack of understanding of moral hazard. Yes, people don’t tend to pay attention to bank balance sheets when making decisions on where to put their money. But that’s exactly what you’d expect to happen if moral hazard were a major problem. People would stop caring about bank risk, and highly risky banks would understand that they could attract deposits every bit as easily as conservative, well-run banks. Clueless depositors are not evidence of a lack of moral hazard; they are evidence that moral hazard exists.
At this point people often shift their argument. They say, “Yes, it’s unfortunate that depositors don’t discipline banks, but you certainly cannot expect average people to evaluate the safety and soundness of large complex banks.” Really? Are these claims also true?
1. Most average people don’t read academic papers and attend lectures at lots of universities, hence you cannot possible expect average people to know that Harvard and Stanford are better that South Dakota State and Western Michigan University.
2. Most people are not able to evaluate the quality of carburetors, anti-lock brakes, and fuel injection mechanisms, so they couldn’t possibly be expected to know that a Mercedes is better than a Ford.
3. Most people are not able to evaluate the quality of surgeons, so they cannot possible be expected to know that Johns Hopkins is better than Missouri Valley Hospital.
Yes, modern Americans pay little or no attention to the relative safety of various banks. Why should they? But I assure you that back in the 1920s people cared a great deal about bank safety. Banks knew this, and managed their balance sheets far more conservatively than do modern banks. That’s why big city banks used to look like massive Greek temples; they had to convince depositors that they had the capital to survive hard times. The vast majority of big banks survived the Great Depression. US GDP in 1929 was about $100 billion and deposit losses during the Great Depression were $1.3 billion. Today, a 50% fall in NGDP (as in 1929-33) would wipe out almost our entire banking system. Modern bankers are far more reckless “despite” regulation. The negative effects of deposit insurance are far more important than the positive effects of regulation.
When people think about moral hazard, they often exhibit a lack of imagination. If you read a great deal of history, you often find yourself asking, “How could people have behaved that way? What were they thinking?” Take an example from the 19th century. One aristocrat insults another at a well-attended dress ball. How would you react? Now think about how you would react if you had been born in 1820. You might respond to the rude comment with a challenge to a duel. Pistols at 20 paces, 6am the following morning. We can’t imagine living this way, because we never experienced this world.
A world without deposit insurance is not that far away. When I was 10 years old (1965), Canada had no deposit insurance and got along just fine. People who live in that sort of world know how to behave. They know enough to put their money in safe banks, not reckless banks. I wish Canada had never adopted deposit insurance. (I suppose their decision to do so represented the misguided big government liberalism of the late 1960s.)
Of course, the US system is much different from the Canadian system. Prior to FDIC, we had lots of bank failures. This was due to the almost incredibly undiversified nature of our system, which resulted from some pretty insane branch banking restrictions. Here’s Elmus Wicker:
The number of commercial banks in the United States nearly tripled during the first two decades of the 20th century, reaching 30,000 in 1920. The vast majority of these were unit banks as required by their national and many state charters. Illinois had nearly 2,000, and Nebraska, with a population of 1.3 million, had a bank for every 1,000 residents. Failures averaged about 70 banks per annum, or one of every 300 existing banks, during those two decades. The agricultural depression of the 1920s raised the failure rate to more than 600 banks per annum, or one of 50. Failures showed few signs of abating as the decade drew to a close, and the banking system, especially in rural America, entered the Great Depression in a fragile state.
LOL at Nebraska. Given the large size of families back then, that’s roughly one bank for every 250 families!
Contrary to widespread opinion, (even among many economists), the bank failures of this period did not lead to much contagion. The only real “panic” occurred for entirely different reasons, when there was (well-justified) fear that the US would leave the gold standard. Otherwise, lots of inefficient small banks failed and life went on.
The Canadians were much smarter. They allowed large well-diversified banks, and thus have looked on with bemusement as the US reels through one banking crisis after another. Here’s the Financial Post:
Despite investor jitters, concerns for the Big Six were limited. Unlike SVB, which catered to a niche market funding tech start-up companies, Canada’s big banks dominate their home market and are diversified across industries and business lines.
“From a Canadian perspective, not only should the failure of SVB not have significant negative implications for our banks, but this crisis should actually be viewed as further vindication of the Canadian banking model, which is dominated by a few large and diversified players,” Bank of Nova Scotia analyst Meny Grauman said in a March 13 note.
In the US, both left and right wing politicians favor the smaller banks. Big is viewed as bad. Matt Yglesias is one of the few progressives that understands the value of big banks, and today he has an excellent post on the issue:
America needs more giant banks
The moral of Silicon Valley Bank’s collapse is that the real danger comes from the medium-sized ones
How do we get to Yglesias’s utopia? Abolish deposit insurance (he wouldn’t agree). You’ll see a massive shift of deposits toward the larger, more diversified banks, making our system resemble the Canadian system.
Most people, and even most economists, know nothing about our banking history. They’ve never bothered to read Elmus Wicker, Larry White, George Selgin, or any of the other experts. They get their ideas from films like “It’s a Wonderful Life.” They view our banking system as a fragile house of cards that would collapse without FDIC. (Funny how the Canadian house of cards avoided any major problems in the century before 1967.) Actually, it’s a house of cards created by FDIC.
The final misconception involves the effect of banking crises on the macroeconomy. It’s true that banking crises are often associated with recessions, but not always. Industrial production soared 57% between March and July 1933, despite many of America’s banks being shut down to check their balance sheets. In fact, in a fiat money system causality generally goes from the business cycle to banking distress, not the other way around. The US entered recession in December 2007. The recession got much worse after June 2008. The banking crisis occurred in late September 2008.
As long as the Fed adjusts monetary policy to keep expected NGDP growth at a healthy level, bank failures should have no significant impact on economic growth. In any case, creating moral hazard doesn’t prevent banking crises, it simply pushes the problem into the future.
FDR opposed deposit insurance, as he (correctly) feared it would create moral hazard. Unfortunately, Congress refused to listen to his good advice.
PS. Some other misconceptions:
“FDIC fees are not a tax on the public.” Yes, they are.
“We aren’t bailing out bank executives”. No, we are not bailing out SVB executives, but we are (implicitly) bailing out their competitors.
Mar 15 2023 at 2:42pm
In a funny way, I’m relieved you were as confused as I was.
Mar 15 2023 at 2:46pm
This is the correct take. Also missing is the fact that depositors wouldn’t lose everything, they would have taken a haircut. Probably only in the neighbourhood of 20%, with 50% made available immediately (guessing). They benefited from the cheap credit SVB offered them, so they should bear some of the costs. Yes, they were less to blame for the insolvency than the managers, that’s why they have first claim on the assets!
Mar 15 2023 at 3:54pm
When I read your post (which I agree with) I mentally added to the start: “Also missing is the fact that depositors wouldn’t lose everything” this time. SVB’s customers didn’t know that risky behavior would be backstopped by the Fed, so they did likely exercise some dilligence. Next time a similar bank will have substantially more incentive to bet it all, assuming they can hoodwink the regulators. Future bank customers will have no incentive to be careful.
Also of note is that the distinction between executives choosing where to put the money rather than shareholders is important. There were several stories indicating that the choice to use SVB was abetted by perks given to the executives by the bank.
Mar 15 2023 at 3:07pm
Non-shareholder executives also have moral hazard problems. Bonuses are typically based on short term deals and performance. If the choices turn out poorly longer term, bonuses aren’t paid back. Sure, the company might go under, but those employees can move on and do it again at the next firm.
When you mention the benefit of large diversified banks, I hope you don’t include banks that are too big to fail.
Mar 15 2023 at 5:01pm
No bank should be too big to fail.
Mar 16 2023 at 8:48am
Nothing, including countries, is too big to fail.
Mar 15 2023 at 3:33pm
I’m not sure that I understand that line. Is that because now SVB’s competitors will not be run?
Mar 15 2023 at 4:56pm
The Fed has now (implicitly) backed all deposits at their competitors.
The Fed has a very generous new program to lend money to struggling banks.
Both are a big benefit to executives at competitors.
Airman Spry Shark
Mar 15 2023 at 3:37pm
Are these restrictions still in place? If so, wouldn’t they need to be removed for an FDIC-less system to be politically-acceptably stable?
Separately, would private deposit insurance have the same degree of moral hazard?
Mar 15 2023 at 5:00pm
The restrictions are gone, but consolidation is slowed by various government policies (restricting mergers, giving more favorable regulation to small banks.) We still have nearly 5000 banks
Private insurance would be better, as long as it wasn’t too big to fail. The market would create narrow banks to serve customers who don’t want to take risks. I’m happy to just park money in a MMMF.
Mar 17 2023 at 10:23am
What do you do as a small business? For an individual using an MMM works but when you have money rapidly coming in and out how will that work? My small corporation typically has a few million in deposits at any given time. Like lots of small businesses we dont really have savings per se as everything goes out to salaries, rent, etc so the money comes in from many sources and goes out quickly to lots of people. Spreading this around to 20 different bank seems like it could cause chaos.
So we have chosen what we think is one of the most conservative banks in our area. As you have pointed out if there is gambling going on the only ones to benefit would be the bankers and the shareholders. We as depositors never benefit and if there is gambling its not clear that we would always know.
Mar 17 2023 at 1:58pm
“So we have chosen what we think is one of the most conservative banks in our area.”
That seems like the right strategy. Canada makes it work, why can’t we?
But why not two or three banks, just to spread your risk?
Mar 18 2023 at 9:31am
Honestly, as someone who had a short stint doing books for an early stage venture backed startup, the fact that we had even two banks made my job a lot harder. And, that was with one of the banks barely being used for transactions. We had about $3m in cash, with 1 $500K burn rate. Trying to spread that out so that we were under $250K in each account, but had enough to pay our bills, and then keep the whole thing organized with records, makes my head hurt just thinking about it.
Mar 17 2023 at 3:39pm
Can’t you get a sweep account?
Mar 15 2023 at 5:44pm
VERY helpful; great context. I’ve read a variety of things on the subject, but this has to be my favorite to date. Two additional thoughts:
Agreed, and well explained. Yet the prevalence of this argument probably signals that the term “moral hazard” misleads people. I expect moral issues to involve conscious choice.
Fun example–but perhaps making the opposite point? Yes, people from households with other people who have gone to college recognize the distinctions between various institutions. But plenty of people–predominantly people from households with limited exposure to college–seem incapable of distinguishing credible institutions of higher education from scams designed simply to separate them from their student loan money. And–surprise, surprise–government has forgiven many of those student loans.
Mar 15 2023 at 7:59pm
But even they know that Harvard is better, they just can’t get in. In contrast, big safe banks will accept deposits from everyone.
Mar 16 2023 at 8:32am
But even they know that Harvard is better, they just can’t get in.
Except that the Dale and Krueger data indicate that Harvard actually isn’t better — that it doesn’t provide more valuable education or even more valuable branding or connections than big state school alternatives. Ivy league grads do better only because Ivy league schools can fill their classes with only the top HS grads. The schools add essentially nothing above and beyond what those same elite students would get elsewhere.
But although this data was widely published at the time, it so contradicted the world views of even smart people (perhaps especially of smart people), it was disbelieved, ignored, and now is mostly forgotten.
That said, with respect to banks and moral hazard, of course you entirely correct. But I’m afraid your points will not be taken to heart by any of those with the power to do anything about it. How much ruin is there in a country? We do seem on course to find out.
Mar 15 2023 at 5:44pm
There’s even moral hazard for employees who don’t get bonuses. Federal DEPOSIT insurance allows employees of closed banks to continue working for 45 days, and then DEPOSIT insurance pays them an additional 1.5 years of salary.
Mar 15 2023 at 6:22pm
WOW–that’s an obscure bit of info. On point, though perhaps beside the point.
Grand Rapids Mike
Mar 16 2023 at 11:55am
Sort of a followup. The SV Bank’s Risk Manage quit in April 2022 and sold the stock in SV. So how long should Bank Management be not allowed to sell stock in a Bank, especially the Risk Manager,
Mar 15 2023 at 6:10pm
This is such a good post! I’ve been trying to make these points to so many people and they are just not interested in it.
Mar 15 2023 at 6:11pm
Scott: “The fact that a business failed and the owners lost everything has no bearing on the issue of moral hazard.” I get your point. Bank executives are as self -interested as anyone. If they know a Fed put, ala Greenspan and Bernanke, exist in the event of a gross failure, bank executives are incentivized to to take socially excessive risks. TBTF and the Peltzman Effect. To Bolster my point, as of today, Swiss National Bank said it will provide Credit Suisse with a liquidity backstop. (Bloomberg News)
Mar 15 2023 at 6:27pm
A few questions/thoughts in no particular order
I’m not sure I follow this. The asymmetry of odds doesn’t change with deposit insurance. Either way, at most the shareholders can only lose the $10 they put in, unless we’re talking about making them personally liable for any losses to depositors? Or, is the idea that bank executives that want to make risky bets won’t have the depositors capital to play with in the absence of deposit insurance, because depositors won’t give them the money?
Thought number 2. Do we have an idea of what percentage of savings was deposited in banks pre deposit insurance and after? How much was stored under a mattress or in other ways unavailable for investment? Are there any correlations between deposit insurance, more risky investment, and more innovation?
Thought 3. In most areas of the economy, specialization is considered good. Better knowledge of the market, more efficiency, better innovation. What’s unique about banking that this general rule doesn’t hold?
Thought 3.5. SVB was generally seen as a major boon to the startup ecosystem, finding new and (mostly) profitable ways to fund startups for 40 years that otherwise would have had trouble getting off the ground. That seems at least partially attributable to the fact that they specialized. That also made them fragile, but it isn’t immediately clear that the societal benefits we’ve gotten are less than the costs.
Mar 15 2023 at 6:28pm
I don’t know why sometimes my paragraphs, quotes, and other formatting just completely disappears after I submit my comment?
Mar 16 2023 at 12:58pm
“The asymmetry of odds doesn’t change with deposit insurance. ”
Yes, it does. If the government is absorbing some of the losses, the banking industry has more incentive to take risks.
Mar 16 2023 at 1:16pm
Can you spell this out for me with some example numbers? Using the Levine example
Without deposit insurance, the math for the shareholder appears to be the same, the only difference is that if you lose without the insurance, both the shareholders and depositors get zero. I can think of two ways to change that story 1) The shareholders/executives are altruistically more risk averse if they think they risk not only their own money, but the money of their depositors. 2) Depositors judge the risk of banks and require a higher rate of return for the riskier ones, raising their cost of capital and consequently the shareholders have to put in more of their own funds.
Either/both of those seem somewhat plausible to me, but is there a 3rd scenario I’m missing? Or one where the $10 only has the chance of turning into $200 with deposit insurance and without it would only turn into $100?
Mar 17 2023 at 11:02am
I think the asymmetry comes in in the access to funds.
If I’m a depositor and my money is insured, I don’t care whether or not I give you (the executives/shareholders) the money to gamble with because I get it back anyway. The banks that take bigger risks can provide more payback to depositors, so I’m incentivized to deposit with banks that gamble.
If my money isn’t insured, then I need to take into account the chance that I lose my deposits. This incentivizes me as a depositor (i.e. someone who wants fast access to my money and a guarantee that it won’t be lost) to deposit with banks that don’t gamble.
You’re right that the insurance doesn’t change the odds. What it changes is the amount of money that the gamblers have to gamble with.
Mar 17 2023 at 2:00pm
It helps to view the bank and the depositors as a single entity, ripping off the taxpayer.
Mar 18 2023 at 9:20am
That’s what I was trying to get at with the cost of capital argument in point 2. There’s kind of a weird circularity though, in that banks that are more risky should have to pay a higher return to depositors to get capital, and one of the ways that depositors can identify the riskiness of a bank is by the fact that they are giving outsized returns.
But this morning I finally read the entire Levine piece (he’s normally paywalled for me, so I hadn’t even clicked on the link before). He brings up the third option that I was too slow to get, which is that the moral hazard really applies to all the non-SVB executives and shareholders, who now get protection against bank runs, but with the likely outcome that they are going to be more strictly regulated and prevented from taking the same kind of risky bets. Hence, the stocks get hammered, but don’t drop to zero as they presumably would have if depositors weren’t rescued and everyone took all their money out of banks.
I also really liked his piece at the end where he quotes Waldman that we want a financial system that overall takes a bit more risk than individuals would on their own, and this leads to positive spillover effects for society. I’m partial to this because it kind of mirrors my own intuition about SVB, sure the bank took more risk than was prudent, but the fact that it existed, and lent to companies that previously didn’t have a lot of financing options, means we probably have some cool tech that we wouldn’t have otherwise had.
Mar 18 2023 at 8:00pm
Dylan, you can get Matt Levine’s Money Stuff for free via email, if you sign up for the newsletter.
(This should be a reply to your comment about the paywall. But the system doesn’t allow such deep nesting of replies.)
Mar 18 2023 at 9:57pm
Thanks for the tip. I used to love reading his columns, but stopped after they instituted the steep subscription price.
Mar 15 2023 at 6:30pm
Deposit insurance gives bank executive an incentive to take socially excessive risks.
This does not apply to the case of SBV where more than 90% of the deposits where not covered by FDIC.
It does not seem that being uninsurance make SBV depositors more risk-alert or SBV managers less willing to take risks. While, on the other hand, having more than 90% of deposits from sophisticated, bank accounting savy (my guess is that Roku CFO knows how to read a balance sheet), uninsured depositors made the bank more prone to a fast unfolding run.
Mar 15 2023 at 8:01pm
I suspect that most Americans believe (correctly) that even “uninsured” deposits were insured. How many uninsured depositors have lost money in recent decades?
Mar 15 2023 at 10:26pm
Ignoring the FDIC limit might not have been ignorance after all. Apparently SVB required its venture borrowers to bank exclusively with SVB. They got good loan terms and that was part of the bargain. Not so innocent.
Knut P. Heen
Mar 16 2023 at 6:40am
The problem is even worse than you describe when it comes to selecting banks. The immoral banks (which take excessive risks) are able to pay higher interests on deposits than moral banks. A moral bank will simply be driven out of business in such a system. The moral bank cannot compete on safety when all deposits in practice are insured.
Mar 16 2023 at 10:06am
I agree with all of your points, except perhaps for the macro effects of widespread bank failures. Given that we’re very far into the era of moral hazard, and seem to be getting even deeper in now, it’s hard to imagine that widespread bank failures wouldn’t represent a significant negative real shock. Also, given the current structure of the Treasury market and the role Treasuries play in monetary policy, failure of the large Treasury dealers, which overlap heavily with the biggest banks, could present problems for monetary policy transmission mechanisms, at least on paper.
That said, I favor elimination of deposit insurance and bailouts, and would like to see experiments with free banking in the US. I just acknowledge that, given how things are structured now, allowing a lot of banks to fail, particularly systemically important ones, can represent real economic pain, even if the Fed keeps future expected NGDP growth on track. I also accept your point that currently, the largest 6 or so banks are more financially solid than most, in part due to regulation, and in part due to diversification. A crisis involving those banks is seemingly less likely than pior to consolidation and Dodd-Frank.
At this point, at the very least, some new regulation needs to accompany the increased moral hazard, which I fear will further suppress innovation as it raises more barriers to entry.
I’d love to see an alternative national bank charter that allows banks to operate independent of most or all regulations, including required deposit insurance, and would statutorially be forbidden to get bailouts. But, it doesn’t really matter what laws get passed, when we have politicians who will pass any laws or accept seemingly any regulations adopted in a pinch which help solve their immediate policitical problems.
Mar 16 2023 at 1:00pm
Yes, we saw with Lehman that an unanticipated application of discipline can be a problem, increasing perceived risk. Unfortunately, each addition of moral hazard makes it harder to extricate ourselves from this mess.
Mar 17 2023 at 9:48am
To your point on moral hazard: I often read that the government performed terribly by letting Lehman fail. However, according to Andrew Ross Sorkin’s Too Big To Fail, during the “Lehman Weekend” John Thain at Merrill Lynch realized ML would become insolvent unless he took action immediately. So he leapt into the arms of Bank of America, accepting terms he would never have considered if he thought the government would be there to bail ML out.
Perhaps the real failure of government was in rescuing Bear Stearns in March 2008; had they let Bear Stearns fail, Lehman management may well have put their house in order. According to Sorkin, Richard Fuld was surprised that the government did not step in to help Lehman in September.
Mar 17 2023 at 2:01pm
“Perhaps the real failure of government was in rescuing Bear Stearns in March 2008”
Mar 16 2023 at 12:45pm
The charitable way to read this is, I think, not “there is no moral hazard,” but “the downside for the executives and shareholders and bondholders is enough to police it.”
Compare with discussions of internalizing positive and negative externalities.
A fair number, according to the FDIC. (Click on a year, and compare the listings where it says that an acquiring bank has agreed to assume all deposits with the ones where it says only that a bank has agreed to assume all insured deposits.)
Uninsured depositors definitely lost money in a number of bank failures through 2008. NetBank was one example. If “recent decades” means since 2008, the FDIC has been making a big effort to reduce that happening by persuading other banks to buy the failed banks (hence moral hazard.)
Moral hazard can be worse when people on one side assume that there is a promise but the other side doesn’t (and isn’t, e.g., charging deposit insurance.)
Mar 16 2023 at 1:02pm
Without looking at the particular bankruptcy cases, there’s not enough information in those links to determine whether depositors actually lost money. Do you have other sources?
Richard W Fulmer
Mar 16 2023 at 2:33pm
Why is this wrong?
Mar 17 2023 at 2:02pm
A recession occurs when NGDP growth slows sharply—that’s bad monetary policy.
Richard W Fulmer
Mar 17 2023 at 3:19pm
Agreed, but wouldn’t enough bank runs cause credit to dry up? Given our fractional reserve system, couldn’t we see deflation as banks call in loans? If so, couldn’t all that lead to a drop in investment and economic activity?
Mar 18 2023 at 8:03pm
The Fed can print enough money to offset these effects.
Richard W Fulmer
Mar 18 2023 at 8:39pm
Setting the stage for the next boom-and-bust cycle.
Mar 16 2023 at 2:40pm
Although times have changed a bit, I’d be willing to support a Hammurabi-type code of conduct for bankers. In our current system there might be some public shaming, but no claw-back of money or bonuses that managers awarded themselves while the ship was taking on water.
Also, my main concern with have a small group of very large banks, like Yglesias suggests, would result in crappier customer service. That situation would only be tolerable with a robust CFP bureau–an entity that President DeSantis will abolish in his first week in office.
Mar 18 2023 at 8:04pm
Just make it easier for competitors to enter the market.
Be that foreign competitors or Walmart.
Mar 17 2023 at 5:13am
How is the coin flip argument at all relevant to the degree to which the government makes depositors whole? The equity-holders equation is always the same, so what on earth has this to do with moral hazard? I’m trying to understand the argument there and in your piece more generally, and I fail. Teach me.
Mar 17 2023 at 2:04pm
It helps to view the bank and the depositors as a single entity, ripping off the taxpayer. Deposit insurance makes that combination less worried about risk.
Mar 18 2023 at 9:34am
I appreciate the thought, but I think this obscures things more than makes it clear. When we’re looking at incentives, you have to look at the individual level, because within any organization you’ve got a ton of people with competing incentives. It’s the interaction of incentives that matters.
Mar 17 2023 at 9:09am
Two other examples of a well-functioning banking system without deposit insurance are Australia and New Zealand. Australia only introduced their “Financial Claims Scheme” in 2008, similarly with New Zealand, whose policy expired in 2012.
Mar 17 2023 at 10:53am
The concentration of bank assets in a few categories is tantamount to gambling.
Mar 17 2023 at 12:22pm
“Deposit insurance gives bank executive an incentive to take socially excessive risks. “Does it? I feel like you’re not considering the fact that there is also a positive externality to providing capital by lending out money (not to mention accepting deposits). Also, the fact that the banks pay into the FDIC insurance scheme should (assuming the price is sufficiently high) mean they are covering that risk by paying the insurance premium.Also, in the absence of FDIC insurance banks would still be the safest place to store assets (arguably there is 0 risk elasticity) and the executives and shareholders would still have the same incentives to make the bets you mentioned. Assuming that the depositors are unaware then, while there is moral hazard, it’s a result of the fact that the investors/executives can’t lose more than their investment not the insurance.
Mar 17 2023 at 2:06pm
I disagree with much of what you say, but this is especially inaccurate:
“Also, the fact that the banks pay into the FDIC insurance scheme should (assuming the price is sufficiently high) mean they are covering that risk by paying the insurance premium”
The fees are structured like a tax, applying to all banks, not just the risky ones.
Mar 17 2023 at 2:37pm
Excellent. One of your best ever.
Mar 18 2023 at 2:32pm
Bailing out the $250k+ account depositors clearly creates moral hazard. The Feds should have limited themselves at accelerating the “winding down” of the long-term positions. In other words, the Feds could have provided depositors rapid access to liquidities (to avoid them waiting for the year-long judicial process to close the bank to come to a conclusion), but also ensure said depositors take a haircut of similar magnitude to the underlying losses the bank took.
Honestly, I struggle to understand why the Feds didn’t pick this option.
Mar 19 2023 at 3:56pm
It seems that the US banking system could be headed towards a consolidation of a major proportion, maybe even monopoly? If the FED guarantees all deposits, does it become virtually the largest shareholder and depositor at the same time? Bank failures are a sign of the free market at work and let’s not forget that these banks also generated lots of income and wealth for many individuals working at, with and for the failed entities over their lifespan. There’s large safe banks in the USA. High rewards come from risk. Having choices is a good thing.
Mar 19 2023 at 6:22pm
Mar 27 2023 at 12:44am
Great article. I think I’ve got this figured out – debts are socialized, profits are privatized. That pretty much sums it up.