Following the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank this spring, U.S. lawmakers have faced a policy head-scratcher. When bank runs happen on the internet, not at the teller’s window, how can the government ensure that smaller and regional banks can meet increased demands for liquidity during moments of panic? Excessive capital requirements would harm smaller banks more than larger ones, while reducing the demand for liquidity by increasing the amount of deposit insurance would create serious moral hazard.
Solving such a complex problem requires a fresh look at deposit insurance. The Federal Deposit Insurance Corp., to its credit, hinted at the answer in a May report on the history and nature of deposit insurance. It asked whether private insurance has a role to play. The answer is an emphatic yes—even if the FDIC doesn’t, so far, seem to agree.
Copyright ©2023 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8
Deposit insurance has been of paramount importance in the stabilization of the world’s banking system. Not only does it help shield depositors from financial loss, it also helps banks manage their balance sheets by creating a buffer against physical and mental capital influences, thus allowing for the orderly functioning of financial markets. However, research suggests that the ability for private markets to add discipline to deposit insurance should not be overlooked.
A joint research paper produced by the International Monetary Fund and the Hamilton Institute of Business stated that private markets can be more effective in encouraging good behaviour in the banking sector than government-backed deposit insurance programmes. This is because private markets create incentives for banks to manage their balance sheets to minimize risk, and therefore reduce the possibility of a financial calamity in the form of a bank run. Private deposit insurance, in the form of securitization or other forms of contractual protection, can provide protection against capital losses due to inconsistent asset values and liquidity issues.
Furthermore, private markets provide a way to limit the amount of government regulation and interference in the banking sector. Government-backed deposit insurance schemes are typically complicated and require a significant amount of legislative oversight in order to ensure their stable operation. Private markets, however, have the potential to relieve governments of some of this burden. Private deposit insurance schemes can be structured in a way that allows banks to tailor their risk management policies to achieve better outcomes and be more mindful of their capital adequacy and liquidity needs, without the need for government interference or oversight.
In short, private markets can provide an effective and efficient alternative to government-backed deposit insurance schemes. They can offer much-needed discipline in the banking sector, while also giving banks the freedom to tailor their risk management policies to suit their specific needs. Private deposit insurance schemes offer a viable option to governments and banking institutions alike, and by incorporating such schemes into their existing deposit insurance frameworks, governments may be able to improve the stability of their banking systems and reduce the overall costs associated with deposit insurance.
