Bank turmoil does not justify the advancement of the mission for deposit insurance

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A sales pitch for insurance salespeople has always been: “I don’t sell insurance, I sell peace of mind.” Regulators and central bankers are now turning similar lines by emphasizing the reassuring qualities of higher deposit insurance over its costs.

But localized banking turmoil does not justify advancing the mission of deposit insurance schemes. For commercial banks and their clients, the detriment would include further erosion of their agency within the financial system. More deposit insurance would also increase implicit subsidies to reckless bankers.

The current zeal for reform is the result of three failures of regional banks in the US and of Credit Suisse. The runs on these institutions suggested that protection was too limited to bolster depositor confidence in a crisis, fueling systemic risk.

Consequently, the Federal Deposit Insurance Corporation has established options to strengthen the financial safety net that it operates. the body has favorably highlighted a possible increase from $250,000 to $2.5 million for daily business accounts. The Bank of England, suffering from what could be described as deposit insurance envy, wonders whether its own £85,000 ceiling It’s appropriate. The European Commission wants to extend the scope of the EU scheme, but without lifting the €100,000 limit. Limited deposit insurance has an obvious utility in preventing bank runs and protecting the cash of the poor. The problem with extending it is that it increases moral hazard.

The theory is that general guarantees encourage some bankers to act recklessly. If they don’t have to worry as much about deposit flight, they can be more aggressive with lending. They can also attract depositors with unsustainably high interest rates.

The nature and extent of moral hazard is a subject of debates as passionate and inconclusive as those related to transubstantiation or quantum string theory. But most sensible people believe that it exists. “It is important to discuss moral hazard if you are looking to significantly increase deposit insurance,” says Peter Tyler of UK Finance, an industry body.

The schemes normally impose the cost of covering the deposits of failing banks on prudent surviving lenders through an industry levy. In the short term, this will reduce profits and shareholder returns. In the longer term, banks will recover the cost from customers.

An important but underestimated aspect of moral hazard is that it can also infect bank customers. Suppose Crazy Ed’s Thrift Store is paying twice the interest as his stolid building society. You are more likely to move your money if you know you can’t lose it. As a necessary evil, deposit insurance caps incorporate judgments on depositors. The generous US ceiling of $250,000 means that a depositor with cash over the limit can afford to lose it and probably should have been more careful.

It follows that when authorities increase depositor protection, they diminish the role of customers, banks, and shareholders as allocators of capital. Markets do this job better than governments, because competition is entrenched. And if you raise deposit insurance too high, “everything becomes a deposit,” as one former central banker puts it. The bankers will rewrite the terms of other investments to bring them under the umbrella.

Therefore, it is up to regulators, central bankers and politicians to show that any expansion of deposit guarantee schemes is necessary and proportionate. Recent bank failures are not proof. The United States made impromptu decisions to extend insurance to all deposits at Silicon Valley Bank and Signature Bank, but not at First Republic. The UK and Switzerland dealt with crises at SVB’s UK division and at Credit Suisse by selling to stronger rivals.

That seems to have prevented contagion. smarter, more selective regulatory adjustments — such as tighter controls on deposit concentration — may be advisable. The United States should also take a close look at “mutual deposit networks”. These automatically distribute large deposits among multiple institutions, none of which hold more than $250,000. Such networks can harm competition by supporting weak lenders. Sheila Bair, who led the FDIC during the financial crisis, describes reciprocal deposits as “classic rent seeking.”

The case for higher deposit insurance is not proven. The regulators’ bias in favor of more regulation also needs scrutiny. Their incentives are also prone to skew, as are those of commercial bankers and insurance salesmen.

jonathan.guthrie@ft.com