The Agenda

A Better Way to Insure Depositors?

A friend recently sent me an excellent January post by Steve Randy Waldman of Interfluidity. Riffing off of an excellent Raghuram Rajan op-ed on the problems with various proposed bright-line rules for regulating major financial institutions, Waldman proposes a tweak. Rajan suggested that deposit insurance might be part of the problem: 

With the advent of money-market funds, households gained access to near riskless deposits. Money-market runs can be eliminated by marking them to market daily; they do not need deposit insurance. To encourage community-based banks, deposit insurance may still make sense because small banks are poorly diversified and subject to bank runs. But for large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way?

Waldman argues that money-market funds aren’t comparable to a state-backed guarantee, that mark-to-market doesn’t limit aggregate risk, etc. But he does offer an alternative approach to deposit insurance that might curb excessive risk-taking:

Rather than insuring banks, the government should insure depositors individually for losses they suffer on deposits at any FDIC-approved bank, up to a pretty high limit (say $1 million, indexed to inflation). Ordinary households would be unaffected by this change, as most families hold balances far less than the insurance cap. They could continue to deposit funds at the FDIC-approved bank of their choice without fear. Affluent households would no longer be able to play the wasteful game of evading insurance limits by splitting funds among different types of accounts and institutions. The affluent would be expected to monitor and help discipline the firms in which they invest. This is both fair and politically credible. It’s fair, because pushing wealth forward in time requires hard information work, and those who wish to push a lot of wealth forward (and earn interest on top!) should contribute to the effort. It’s credible, because ex post facto bailouts for underinsured depositors would be a hard sell when the underinsured include only wealthier depositors, who would not be reduced to penury but, at worst, to a level of affluence most households never achieve, simply by maxing out their government insurance.

So in essence the goal is to get affluent investors to use their resources to help monitor the creditworthiness of banks, relieving some of the burden on regulatory bodies that have demonstrated their limitations again and again.

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.

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