A little more on privatizing FDIC insurance.

. Why are we entertaining solutions that would reintroduce “commercial bank runs” into our daily worries? Finding a solution to this is one of those things we got right in the 20th century. Figuring out a way to solve the “capital shadow bank runs” is what we should be focused on, not reintroducing old problems.

This one is really fun. Cato (2001):

Federal deposit insurance is a tax on bank deposits that forces consumers to involuntarily purchase unnecessary government-provided insurance at government-set rates. Born of the Great Depression as temporary legisla- tion later made permanent, government deposit insurance was intended to maintain consumer confidence and prevent bank runs, but modern financial institutions are better diversified and less at risk than were finan- cial institutions during the Great Depression….

The last time major bank runs occurred in the United States was during the months before FDR was inaugurated. Depositors, speculating that FDR would devalue the dollar against the gold standard to inflate prices, raced to withdraw funds and convert dollars into gold coin and bullion at the old rates…

Financial innovations have also allowed banks to reduce risk. Banks can hedge with derivatives against abrupt changes in interest rates that would otherwise adversely impact bank assets. Sophisticated financial models enable banks to purchase portfolio insurance. Financial instruments can protect spreads and limit risk from mortgage prepayment. Today’s banks are less at risk because they hold pooled mortgage-backed securities. Small banks of yesteryear borrowed short from depositors and lent long, holding the local home mortgages they originated to term. Their assets were composed of illiquid and geographically undiversified loans, which made it difficult to raise cash if needed to finance depositor withdrawals…

The probability of a banking panic is more remote today because of innovations in the banking industry, not because of the FDIC and mandatory government-run deposit insurance. There is little reason to expect systemic depositor withdrawals. In fact, slow withdrawals isolated to substandard banking institutions in small doses are beneficial to the health of credit markets. Deposit insurance, meanwhile, increases moral hazard, because not-at-risk depositors have
little incentive to steer their funds away from unsound and ailing banks that promise higher returns toward sound and healthy banks. Instead of private markets gradually stopping the flow of funds to inefficient financial intermediaries, government is left in control to abruptly end a bank’s operations after a misallocation of capital that otherwise might never had occurred.

Sorry for the long quote but:

1. They blame FDR for the last banking crisis.
2. Banks today, in 2001 that is, will never have a financial crisis because:
a. They hold mortgage backed securities.
b. They have exposure to the entire country in mortgages (geographically diversified) and there’s never been a nationwide housing bubble.
c. risk management has evolved so they know what they are doing. “Sophisticated financial models enable banks to purchase portfolio insurance” is wonderful in a post-AIG world.
d. implicit in their argument is that “shadow banks”, which borrow from credit markets instead of from depositor are more reliable because they are more liquid (and they are more liquid because they can panic quicker as we found out!).
3. They note how well this depositor funding market has worked post-war but assume away the government or FDIC is a part of that success.

Happy days are here again; we’ll never have a wave of commercial bank failures in our real economy in the 21st century because of things like value-at-risk and monte carlo simulations.

Lots of people called things wrong, but that’s exactly the reason we want a government that acts as a risk-insurer of last resort. You shouldn’t go bankrupt because you fall off a ladder. You also shouldn’t have your short-term savings wiped out because people thought creating mortgages exposures to the national market would be risk-free.