The Moral Hazard of Bank Deposit Guarantees

Fears of a banking meltdown have paved the way for the Irish government to increase bank deposit guarantees to a massive €100,000. But as Patricia A. McKoy (2006) wrote for the IMF, socialising deposit risk fosters even more irresponsible activity.

In the deposit insurance context, moral hazard manifests itself in two ways. First, explicit deposit insurance gives insured banks incentives to pursue added risks because they can capture any profits but shift any losses to the government. Second, explicit deposit insurance reduces incentives by depositors and shareholders to monitor their banks. As Professor William Lovett put it, “If governments and modern nations do not allow most banks to [fail], how can the leaders and managements of banking institutions be disciplined and avoid unduly risky, negligent, or adventurous lending policies (or simply poor asset-liability management)?”

What exactly is the problem?

In a world with no deposit insurance, a bank that is considering making a risky loan knows that it will have to pay depositors more for taking on the added risk. Either the bank will pay the risk premium or it will not make the loan. In a world with deposit insurance, however, insured depositors will not demand a risk premium because they know that the government will insure their deposits up to the legal limit, regardless whether the bank makes the loan. Thus, deposit insurance gives banks incentives to take added risks – either by increasing their leverage or investing in riskier assets — thereby increasing the government’s exposure to losses. These incentives are especially strong for undercapitalized banks. Moral hazard will exist so long as the total expected profits from a bank’s asset portfolio exceed the explicit costs of deposit insurance (premiums) plus its implicit costs (the costs of regulation).

McKoy goes on to explain some techniques by which the moral hazards associated with bank deposit guarantees can be limited. She notes that in certain circumstances these measures have probably played a strong role in preventing bank runs.

I wouldn’t disagree with those points, but it’s still the case that bank failures and similar disaster scenarios, far from being the cause of economic crisis, are usually best thought of as symptoms, effects, and parts of the cure; in other words, that bank catastrophes teach important lessons which should, in the long run, help prevent the type of destructive bubble behaviour which brings them about in the first place.