Deposit Insurance

November 1995
Deposit insurance was the peculiar creation of the U.S. banking experience generated by some of that system's worst features. It is inappropriate for developing or transition economies. It presents enormous incentive problems and demands additional regulations and close supervision to make it workable in the short run. Simpler, less costly alternatives may achieve the same objective.
Should deposit insurance be recommended? No. History teaches three lessons:
° Deposit insurance was not adopted primarily to protect the depositor. There were many ways to increase the soundness of the banking system, and the problems of deposit insurance were well-known from the state experiments that preceded the FDIC. The leading alternative with which contemporaries had experience was to allow branching and the diversification of institutions by geography and product line. But monetary contraction and the politics of the banking crisis empowered small banks instead.
° The history of federal and state insurance plans shows that it is all but impossible to escape the moral hazard and other problems inherent in deposit insurance, as Canada learned when it adopted it in 1967.
° In setting up banking regulations, including deposit insurance, a banking lobby will be created that will campaign to protect the industry as it stands, and the industry will be pushed on a course that will be difficult to alter. The state experience also contains a lesson: If the government is willing to reduce competition, allow tight cartelization, and impose tight supervision and control, deposit insurance can work for at least 20 years.
The public is greatly concerned about the safety of its deposits and U.S. financial history is littered with schemes to protect depositors or note holders. The designs of these systems were influenced by special interests but were also driven by the public's desire for protection. The key problem is one of information: For households and small businesses, it is costly to monitor the performance of banks and decide which is safest, especially when the economy is subject to fluctuations.
What plan could a policymaker offer that would not have all the perverse effects of deposit insurance? There is a strong historical precedent for at least one alternative: regulators could require each bank to offer deposit accounts that are segregated, treasury-bill mutual funds. This type of account is effectively insurance from the government, with the same guarantee as government bonds, but without the wrong incentives for financial institutions that arise from deposit insurance.
This paper --- a joint product of the Finance and Private Sector Development Division, Policy Research Department, and the Financial Sector Development Department --- was presented at a Bank seminar, Financial History: Lessons of the Past for Reformers of the Present, and is a chapter in a forthcoming volume, Reforming Finance: Some Lessons from History, edited by Gerard Caprio, Jr. and Dimitri Vittas.