Bank Deposit Insurance: The Case for Stability and Reform

Introduction

The 2023 financial turmoil caused by the collapse of several financial institutions underscores a crucial historical lesson: financial stability is undermined when market discipline is used as a tool to govern the liability side of bank balance sheets, a point made by Mosler many years ago.

In a new paper (based on work I began in 2019), I argue that bank failures in the UK and US which took place fifteen years apart—Northern Rock (NR) and Silicon Valley Bank (SVB)—offer valuable lessons for financial regulators by demonstrating the ineffectiveness of relying on uninsured creditors to exert market discipline. The chief implication—echoed by two prominent US academics in 2024—is that deposit insurance limits at commercial banks ought to be abolished.

The Purpose of Deposit Insurance

Bank deposits remain by far the most significant medium of exchange in modern economies, and economies with large financial systems are vulnerable to the consequences of banking panics. Deposit insurance exists to maintain confidence in the banking system, especially during crises. Recessions instigated by banking sector turmoil are generally much longer and deeper than those of other varieties, thanks to the dependence for economic growth on bank-generated credit, and it is therefore unsurprising that the authorities wish to prevent or mitigate financial crises when they occur.

Critics of deposit insurance argue that such insurance incentivises banks to take excessive risks and diminishes depositor vigilance because bank creditors know their claims are at least partially insured and therefore fail to monitor risk-taking adequately. These behavioural responses are common drawbacks of any insurance scheme.

However, some empirical evidence challenges these theoretical concerns. Contrary to received wisdom, the most important of these studies demonstrate that in countries with strong regulatory environments, the impact of deposit insurance on banking system fragility is statistically insignificant. In a framework with (predominantly) sophisticated uninsured creditors acting as monitors, in environments characterised by the presence of strong institutional and legal safeguards, the implication is that market discipline often fails to function as claimed in the literature on bank stability.

Northern Rock and SVB

Using the NR and SVB failures as case studies, my paper highlights certain inadequacies in relying on depositor and creditor discipline to support financial stability. Whilst the precise circumstances of each bank differed, there were numerous common elements to their respective collapses. Most importantly, both instances demonstrated that even sophisticated investors failed to monitor their counterparts effectively. This is even more surprising given that these failures occurred against the backdrop of rapid growth in the institutions concerned and the banks in question were not engaging in complex trading or hidden off-balance sheet financing: the risks that each bank assumed were highly transparent.

If it is the case that any time a medium or large-sized financial institutions in the US or UK is threatened by insolvency, that the respective authorities are compelled to guarantee their liabilities, then those liabilities are de facto guaranteed by the state, even where explicit deposit insurance schemes subsist. In these cases, unsecured creditors are bailed out, destroying the foundation of any claims concerning moral hazard.

Implications

If the moral hazard thesis is flawed, it is time for new thinking on the role that insurance plays in bank regulation. This is even more significant given the fact that, in times of crisis, even medium-sized banks appear to benefit from an implicit guarantee of their deposit bases: NR and SVB were by no means systemically important in terms of asset size in their respective jurisdictions but fears of contagion in each case led to regulatory intervention.

Widening bank deposit insurance would have the following financial stability inducing benefits:

• Panic-Proofing Banks: Unlimited deposit insurance eliminates depositor runs, which are now more rapid than ever, enabled by modern technology and social media;
• Enhancing Competition: Limiting insurance disproportionately benefits larger banks perceived as safer, skewing competition and raising funding costs for smaller institutions;
• Reducing Shadow Banking Risks: Insurance caps push large investors into shadow banking, a key contributor to the 2007-09 Global Financial Crisis (GFC). Comprehensive insurance would compress the largely unregulated shadow banking system.
• Simplifying Regulation: Blanket insurance would reduce the need for complex liquidity regulations, allowing a shift in focus to asset quality oversight.
• Monetary Policy Benefits: Central banks would gain more control over monetary policy by reducing the dispersal of money-like liabilities across the financial system.

Addressing Challenges

There is no doubt that providing blanket insurance to bank deposits might increase moral hazard levels to some degree. In return for such benefits, therefore, banks would be subject to a more rigorous assessment system, including safeguards including:

• Activity Restrictions: Measures to separate high-risk trading from core banking activities, such as the UK’s ring-fencing rules;
• Increased funding of the Insurance Scheme: Current deposit insurance funds are underfunded and reliant on public backstops—adequate funding mechanisms are critical for sustainability.
• Regulatory Reforms: Extending insurance coverage should be paired with tighter prudential measures to mitigate moral hazard and enhance bank resilience.

Conclusion

Whilst seemingly controversial at first glance, introducing unlimited deposit insurance for commercial banks would merely reflect the extant position that subsists, where even medium-sized institutions’ deposits are guaranteed during systemic distress. These dynamics result in a suboptimal blend of implicit government guarantees underwriting the entire financial system, giving rise to free-riding behaviour and introducing risks which are often hidden and not priced into bank or investor costs.

The author’s complete paper can be found here.

Jay Cullen is the Head of School of Law and Criminal Justice and Director of the Business School at Edge Hill University.