Ebook Deposit Insurance, Bank Regulation, and Financial System Risks
Many financial contracts have the primary purpose of transferring risk between different economic agents. In recent decades, innovations by private financial institutions and markets in the form of derivatives and other securities have expanded the opportunities for allocating risks. However, for many years the federal government has offered insurance contracts that shift risk from private entities to taxpayers. Its role as an insurer of private risks continues to be large despite the private financial innovations that might be expected to supplant it.
This paper considers how the largest federal insurance program, deposit insurance, influences financial system risks. I focus on how the presence of this insurance can change the investment decisions of individuals, banks, and firms. While a government deposit guarantee may produce risk-sharing benefits, I argue that the current methods for pricing this guarantee and for regulating banks are leading to new forms of moral hazard that are killing off efficient private financial innovations. Moral hazard is also created because insurance mis-pricing and capital regulations have the effect of subsidizing systematic risks. I then explore the possibility that there are alternative ways that a government might offer deposit insurance that produce less inefficiencies.
As a starting point, I present empirical evidence on how deposit insurance has influenced the role of banks as providers of liquidity. In particular, I re-examine the question of why banks appear to have an advantage in offering the off-balance sheet services of loan commitments and lines of credit. My evidence relates to recent research by Kashyap, Rajan, and Stein (2002)(hereafter referred to as KRS) who present a model that explains why it is efficient for banks to simultaneously provide liquidity to borrowing firms in the form of loan commitments and to depositors in the form of demandable deposits. They show that under particular conditions, the coexistence of commitments to future lending and commitments to allow future withdraws of deposits creates an economy of scale that conserves on the amount of costly liquid assets that are needed to support these commitments. Using recent banking and financial market data, Gatev and Strahan (2005) (hereafter, referred to as GS) present empirical evidence that supports KRS’s prediction of synergies in loan commitments and deposit taking.
I add to this research by showing that prior to the establishment of the Federal Deposit Insurance Corporation (FDIC), banks did not appear to embody the synergy proposed by KRS. I do this by replicating some of the tests carried out by GS but using pre-FDIC data. My results cast doubt on the notion that banks efficiently provide liquidity due to their inherent financial structure. Rather, their ability to specialize in liquidity provision appears to be linked to the federal safety net provided by deposit insurance. Furthermore, I show that even in modern times, there may be financial institutions other than banks that can serve as conduits of liquidity to borrowers.
If the FDIC is critical for banks’ role in hedging liquidity risks, a natural question is whether the current system of deposit insurance and bank regulation is the best arrangement for providing liquidity or whether an alternative institutional structure would be better. To answer this, I begin by noting that it is difficult for a government to properly evaluate financial risks, particularly default risks that vary systematically over the business cycle. This makes it hard for a government to set insurance premiums without distorting banks’ cost of financing. There is a natural tendency for governments to subsidize deposit insurance and require too little bank capital, even under risk-based capital standards such as Basel II. The inefficiencies from this subsidization have been magnified due to recent U.S. legislation that expanded financial services firms’ access to bank deposit financing. Moral hazard has been exacerbated and risk-reducing private financial innovations have been stifled.
Given that a government insurer is unlikely to properly price risks, but that there is a social benefit to the liquidity provided by a government guaranteed, default-free transaction account, I explore whether alternative institutional structures might improve upon the current system. I present a model that suggests that moral hazard from government mis-pricing can be mitigated by an alternative financial architecture.
The plan of the paper is as follows. The next section presents empirical evidence on the behavior of banks during 1988-2004 as well as during the pre-FDIC period of 1920-1933. The results suggest that banks were able to hedge against liquidity shocks during recent times but not when they lacked deposit insurance. This section also examines whether another financial institution, a money market mutual fund, has the potential to hedge liquidity shocks. Because deposit insurance appears critical for banks’ ability to hedge liquidity risks, Section III studies potential problems with government insurance. It presents evidence of recent moral hazard incentives created by the government’s inherent limitations in assessing bank risks. The situation appears to have worsened since the Gramm-Leach-Bliley Act of 1999 expanded access to deposit insurance.
Section IV presents a model of banking when risk-based deposit insurance premiums are set according to reforms proposed by the FDIC and when risk-based capital standards are implemented according to Basel II. It predicts that such risk-based regulations provide incentives for banks to invest in loans and off-balance sheet activities, such as loan commitments, with high systematic risk. These incentives have the potential to increase the pro-cyclicality of the economy. Section V then considers an alternative government insurance system that can potentially mitigate these distortions to risk-taking. Concluding comments follow in Section VI.
Download
PDF Ebook Deposit Insurance, Bank Regulation, and Financial System Risks
Posted in :
