Congress’s new and improved bailout bill includes, along with the obligatory helpings of pork, a provision that would increase FDIC bank deposit insurance from $100,000 to $250,000. Should the House pass the bill today, that boost in insurance would let a lot of Americans sleep a lot easier.
And that’s the problem.
When the government provides free insurance for an investment – any investment – it removes considerations of risk from investors’ decisions and, as a result, it distorts financial markets. In the worst-case scenario, that contributes to the kind of craziness that has put the world economy on a precipice. As Floyd Norris writes in the New York Times today:
As the ideas fly for saving the financial system, it is amazing — and appalling — how many of them seem to be straight out of the playbook from the savings and loan crisis. Then, as now, Congress decided to reassure investors by more than doubling the amount of deposits that could be insured … The raising of the deposit guarantee limits in 1980 to $100,000, from $40,000, made depositors less concerned about the health of their institution, and made it easier for dying institutions to attract deposits. Raising the figure to $250,000 now could have the same effect.
I’m not suggesting that insuring bank deposits is a bad thing. An even worse worst-case scenario is the kind of panic that leads to general runs on banks. What I don’t understand is why the insurance is set at a full 100% rather than, say, 80% or even 90%. By putting some fraction of deposits at risk, you’d at least provide a little incentive for people to be conscious of the health of the bank in which they’re putting their money, which in turn would put some additional pressure on banks to temper the risks they take.
Even if Congress had kept the full insurance on the first $100,000 of deposits and then provided 80% insurance for the next $150,000 of deposits, it would have injected a little more rationality into personal banking decisions. When it comes to money, panic is bad but nervousness is good.
The Economist has a good article about deposit insurance in its current issue:
http://www.economist.com/finance/displaystory.cfm?story_id=12342681
They make a couple of interesting points:
— Insurance doesn’t always guard against bank runs, as in the case of Northern Rock, because people may still fear that getting their deposits after a bank failure might involve delays and red tape.
— The limits on insurance can be a fiction since any depositor losses are politically hazardous. Wachovia’s rescue insured all deposits.
I have my ready cash in Washington Mutual, and it crossed my mind to pull it out, but I held my breath and left it there, though they did experience a mini-run that was apparently the final nail in their coffin.
But I gather that some people were shifting deposits around to stay within the $100K limit, and this must have caused difficulties for some banks.
How do you expect ordinary people to be conscious of the health of the bank when even powerhouses like AIG whose primary job is to asses risks can’t handle that task?
I’m sure many people in AIG handled it just fine, then fudged it all so they could keep their jobs.
Ordinary people have never believed that cash deposits can be risky, so would simply blame the government anyway. They might as well admit that they’d never let a bank fail to that extent. I think as long as there is any gov. deposit insurance, altering it will affect the distribution of money rather than the amount that has to be insured.
See http://www.bankrate.com/brm/news/sav/20030820a1.asp
I guess I’d disagree with Norris on this one. I don’t think that bank depositors had anything to do with this banking crisis, unlike the S&L fiasco. Back then, the rotten S&L’s were funding themselves by offering above-market CD rates. This time around, the funding came from the entire deregulated financial sector.
Everybody was complicit, from the borrowers who lied about their income and net worth, to the lenders who ignored underwriting standards, to the packagers of subprime loans who turned a blind eye to the resulting crapola in return for their packaging fees, to the leveraged vehicles stuffed full of these securities. Probably the only white hat in the mix was the depositors.
This bank bailout will increase the moral hazard in the financial sector, no doubt about it. I don’t think that the increase in FDIC insurance has any such downside, however. Its the purchase of loans for above-market prices that will increase moral hazard within the banking community.
Nick,
Any discount on the insurance would just about completely negate its utility at suppressing bank runs.
Let suppose I have $100,000 deposited in Bank A. I scrutinize and estimate that the likelihood of Bank A failing tomorrow is a shockingly high 1%. So I have a 1% chance of losing, in your system, 10% of my money or $10,000.
Expected return on moving my money? .01 * $10,000.
The only question left is does it cost me less than $100 to move my money?
-t
Also, quite simply, the level of deposit insurance should be tied to constraints on a banks leverage. A bank should not be permitted to leverage federally insured deposits at all except for other kinds of federally insured debt. The limit on federally insured deposits should be extremely high, in fact — limited only by the quality of enforcing the “no-leveraging” requirement for those deposits.
Yes, yes, I know: that would take an enormous amount of cash effectively out of the finance market except to the extent that small depositors might be willing to risk using uninsured forms of banking. It would essentially move all small, insured deposits into treasury bonds and thus at first glance looks like a socialization of the non-retirement, non-investment savings of hoi poloi.
Or would it? It wouldn’t be socialization, not quite, at least if small depositors are free to choose uninsured alternatives.
-t
Interestingly, no. Banks used to pool the subprime into entities. The senior bonds used to fund these entities were usually AAA-rated. Which made them acceptable collateral for regulated banks, life insurance firms, etc. The reason the investments were so opaque was to fit them into the regulated sector.
I like Tom’s idea of segregating insured deposits from risk taking at banks. Although why not just issue $1 gilts, or use treasuries-only money market funds (which already exist)? Maybe we need to get rid of the idea of a risk-free investment all together.
Some blog cross-over.
I took the Nick-inspired idea of segregating insured from uninsured deposits and making very high reserve requirements on insured deposits and turned into a longer “top-post” on a different blog. I find the more fully developed idea kind of interesting and would like to see some smart folks point out any obvious (but not to me) holes in it.
So, the more developed form of the idea is over at technocrat.
-t
And technocrat’s post attracted some good comments. The main issue I’d have with Tom’s proposal as he’s stated it, is that his fully insured deposits are only backed by government assets. Which either limits them to the amount that government needs to borrow. Or the government has to become/create a bank to lend out the surplus insured deposits.
I’d prefer a small tightly regulated “public utility” deposit banking system, which only lends short-term on real collateral. This could form the legal-tender money supply for clearing taxes, etc. Risky and/or long-term capital formation taking place in the securities market instead.
In a democracy, maybe the thing that matters most is what people feel ought to be safe, because they can direct the government jail a few people and throw money at it to “make it better”. Few swing voters complained that a new family could barely afford to live in the SE on a single professional salary. *shrug*
Anyway, back to writing job applications for me! Here are some securitization essays I prepared earlier :-)
Thomas,
People are so accustomed to the idea of a treasury bond being backed by little more than “full faith and credit” that I think the idea of a taxpayer preferred bond isn’t fully clear.
A taxpayer preferred bond is basically a way for anyone in the economy who holds some cash to say “Ok, register this cash as ‘out of circulation until date so-and-so (or earlier, at a discount)”. It’s little more than that. It doesn’t need a bank in the conventional sense to administer such an instrument. The deposits backing taxpayer preferred bonds are simply never lent out.
That’s why it’s an appropriate role for government: there’s no profit in issuing these bonds.
If this form of bond existed, it would provide a foundation on which you most definitely could (and should) build the kind of public utility banking system you describe.
Another way to see the idea is to think of how such bonds make “playful adversaries” out of the central bank and the market. When the central bank is too liberal with credit, the market can demand greater proven reserves in the form of these bonds and thus counter by taking money out of the market. When the central bank is too tight, if the market as a whole has built up a surplus of proven reserves, it can decide how much of that to release to compensate for the central bank’s meanness.
-t
My understanding is as follows, and I’d be interested in knowing if I’ve missed the point: The real problem as I see it is that the financial markets need to feel the pain, but the general population doesn’t. The two critical factors are credit and employment. If people can’t get loans, that seizes the gears of business – particularly small businesses, and grinds demand to halt both for consumers and B2B. If businesses can’t get new credit at an affordable rate, and the rates go up on existing loans, while demand slows, they probably end up laying people off. A rise in unemployment combined with difficult and expensive credit means a real recession that hits ‘real’ people. The credit situation is rooted in the inter-bank lending problems, and that is rooted in the fact that confidence between banks is at rock bottom. To fix that, a large cash injection in the form of credit to effectively replace stalled inter-bank lending is required, along with guarantees aimed at restoring trust in and amongst the banks. Doing that, however, distorts the financial markets as you suggest. Surely the only real solution is for lawmakers and regulators to tack against the wind – now they bail out, but on the uptick they introduce regulation and try and cool things down. Trouble is that they will face wails of agony that they are interfering with growth, and our memories are so short…
Surely leverage is matter of judgement. A bank has deposits as liabilities, and assets [mortgages, securities, buildings..] on the other side.
I’m not clear on what’s on the other side of a tax-payer preferred bond.
Logically: a stack of physical dollar bills for most of the value — you could in principle insist on having an inventory of them by serial number. In practice it doesn’t have to be quite that literal, of course — just “effectively the same thing”.
In other words, a slice of “M0” but it doesn’t literally have to be slips of paper.
A collective (long term) goal of the market might be, for example, to prefer situations where (among other conditions) the total size of taxpayer preferred bond deposits is, I dunno — as a first guess — say about half the size of “M3” with a quite low average ownership amount of those deposits. Shorter-term, well short of that level of deposits but still with no upper bound on the size of a deposit they should (I’m thinking, still open minded to be dissuaded) they should be a good wedge for applying market forces against excessive and irrational leveraging based on poorly understood, overly complex instruments. They give a way for people to demand “put your money where your mouth is, if you think your insurance offer on bond X is such a good bet. Your math is too tricky for me to follow but it might be right so I’ll pay a little more to see you actually put up the cash here.”
-t
M0 is a cash claim on the government. (Paper that makes tax men go away and not steal your stuff.) I’m not entirely averse to the idea of only using government paper as legal tender. Although, that would mean finding new ways to finance trade credit, wages, etc…
But I’m uncertain what a tax-payer preferred bond would offer over a normal treasury bill. You buy a claim on a sum of money at a point in the future in either case. Everything else is just internal accounting?
(Most CDS have collateral requirements, and the preferred collateral is treasuries. So that’s your market wedge. There are structures that just write CDS backed with treasuries :-o)
So, Thomas: just to reiterate I am kind of soliciting for counter-arguments here in that I don’t feel certain that taxpayer-preferred bonds are a sensible idea and I would like to see refutations. So, thanks, although I’m not sure you’ve actually refuted here and let me answer you in this context.
Adopting your framework (trying to) and extending it:
M0 is a cash claim on the government — right.
You can’t (sans horse trading) pay your taxes in T-bills but you can in dollar bills. Right.
A taxpayer preferred bond is a way to convert a stack of physical dollar bills into a more convenient and more easily authenticated instrument of exactly the same worth. E.g., there is no need to physically store the bills — we can just record their serial numbers as bits, make sure the record is secure, burn the physical bills, and re-print those same bills as needed on demand.
That creates a basis for markets to compete to determine a reserve level. That basis doesn’t currently exist. A T-bill payout at maturity can be satisfied by skimming off revenues or by printing new money — could go either way. A taxpayer-preferred payout at maturity is satisfied by handing back a slice of M0 that was taken out of circulation.
Hopefully this kind of instrument makes an “honest, assured reserve” negotiable among people. Hopefully this kind of instrument helps a market to better determine the credit/money supply in the long term, rather than centralizing it among a few overwhelmed blowhards who are mostly crony’s and political appointees and anyway that small a number of people can’t possibly be well informed enough to make wise decisions about something as complicated as the price of money.
-t
That you can’t pay taxes directly in treasuries isn’t really relevant, you can hand the note to the Fed to get dollars to pay taxes. That takes less than a second. It’s possible to have dollars deposited with the Fed anyway if that’s what you want. They even pay interest on it now.
The big issue with a “no leverage” system is that I can’t take an invoice from my business to the bank and get fresh money to pay my staff. Or at least this could not be funded with customer deposits. The entire system of trade financing that banks were created to run would simply no longer work. Without alternatives (and there are some potentially good ones) all long distance trade, and most smaller business would collapse.
In “no leverage” world, the government would be left determining the value of the dollar through taxing, spending and borrowing. A good or bad thing depending on perspective.
Article in the WSJ today reports Sheila Bair at FDIC proposed a 90% guarantee option to Treasury and the Fed.