Deposit insurance isn’t the moral hazard you think it is, new report argues
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Everything you thought you knew about moral hazard in the banking system is probably wrong. That's the provocative yet compelling message from a new paper by two economic sociologists, Kim Pernell and Jiwook Jung.
Why it matters: Policymakers worry greatly about deposit insurance and the way in which it allows or even encourages excessively risky behavior on the part of banks. That moral-hazard argument is often given as the prime reason why deposit insurance shouldn't be increased to, say, $25 million.
- The data collated by Pernell and Jung, however, suggest that the opposite is the case — that, in fact, a bigger government backstop reduces the amount of dangerously risky behavior banks get up to.
The big picture: The real question is what causes bank executives to take excess risk in the first place. Much of the economics literature simply assumes that, no matter how high their profits already are, bankers will always seek to increase them unless they are monitored and restrained by the market.
- One economist, Columbia's Charles Calomiris, has identified the government safety net as "the greatest single source of financial fragility," since it limits downside risk while keeping the upside unlimited.
- Pernell and Jung, on the other hand, come not from financial economics but rather from economic sociology. They hypothesize that risk-taking is caused by profitability pressures, and that when it's hard to make a profit, executives will take ever-greater risks to get there.
How it works: When banks can depend on low-cost and stable government-guaranteed deposits, that "dampens the profitability pressures organizational executives face, reducing their propensity to take excessive risks," write the authors.
- In other words: A banker with a stable base of insured deposits faces much less pressure to find profits than one struggling to fund every new loan.
- What's more, government regulation itself reduces the pressure on bankers to chase profits, which is one reason why it was relatively unregulated investment banks like Bear Stearns and Lehman Brothers that were the first to fail during the financial crisis, rather than more closely regulated deposit-taking institutions.
What they found: The best way to settle the argument between the economists and the sociologists is to look at the empirical evidence rather than what happens in theory.
- Looking at banks' activities between 1994 and 2015, the paper finds that "greater bank dependence on insured deposits was generally associated with a net reduced or neutral effect on risk-taking."
- T00-big-to-fail banks also generally take fewer risks: "Crossing the $100 billion asset threshold was associated with significantly lower leverage, higher regulatory capital, and less imprudent lending." (Large banks do, however, hold much more in the way of derivatives, partly because small banks are generally too small to even participate in those markets.)
The bottom line: Government involvement makes banks safer, not riskier.
