Will Expanding Deposit Insurance Coverage Prevent Bank Runs?

The answer is NO, as I explain below.

The Senate has passed the modified bailout package.  The TARP is still the central part of the package.  As I argued earlier, attempts to use of asset management companies to deal with financial crises failed in many countries including Japan.  The package does not have anything to encourage or force recapitalization of the financial sector, which is necessary to end the crisis.  The package does not provide any mechanism to deal with failures of systemically important non-banks, such as Lehman: the government just hopes they will not fail anymore.  Thus, as far as the part that is relevant for the financial system stabilization, the modified package is not a significant improvement over the original bailout plan that many criticized and the House rejected.

On addition to the package this time is the expansion of deposit insurance coverage.  It increases the coverage limit of deposit insurance from $100,000 to $250,000, and allows FDIC to request the government to cover unlimited amount of losses.  The protection of bank liabilities is another tried and failed policy to deal with the financial crises in many countries.

Again, my example comes from Japan.  Japan established an explicit deposit insurance system long before the banking problems started.  After the Japanese banks started to suffer from the bad loans in the 1990s, the Deposit Insurance Act was revised in 1996 to temporarily lift the coverage limit of ¥10 million (about $95,000) per person per bank.  Thus, all deposits were insured without limit.  The limit was supposed to be reintroduced on April 1, 2001, but it was later postponed to April 1, 2002, and even then it was only gradually lifted (first for time deposits, and then for ordinary deposits). One can argue the full insurance on deposits in Japan prevented traditional bank runs (people literally rushing to bank branches to withdraw their deposits), but depositors nonetheless shifted their deposits from clearly troubled banks to relatively healthy banks.  Many people shifted their savings from private sector banks to the postal savings, which was government-owned, or into cash.  In this sense, there was a “silent” bank run.

More importantly, the full insurance of deposits did not prevent the banking crisis in Japan in November 1997, when several banks and security houses (including Hokkaido Takushoku Bank, a major bank, and Yamaichi Securities, one of the big four security houses) failed and the interbank loan market (call market) collapsed.

The experiences from other countries, including Japan, suggest the bailout package is not likely to work.  If the alternative was a complete meltdown of the financial system (whatever it means), L-shape stagnation like Japan would be certainly more attractive.  We may soon consider Japan in the 1990s as a successful case of responding to a large negative asset price shock.  The economy did not grow, but many people maintained their quality of life.  It was not like the Great Depression.  Could Japan have done better?  Yes.  Can the US do better?

13 Responses to "Will Expanding Deposit Insurance Coverage Prevent Bank Runs?"

  1. Alan Harvey   October 2, 2008 at 3:10 pm

    Thank you for this. There is no finessing the recapitalization.

  2. Guest   October 3, 2008 at 1:41 am

    When will the prosecutions for this pyramid scheme take place?

    • Guest   October 3, 2008 at 8:48 pm

      You are correct in your comment (pyramid scheme). To add, here is a riddle…if our banking system gives a ‘customer’ a loan (which is the principle amount), from where does the interest money come from (to be paid back to the bank along with the principle)?Answer: Another loan must be taken (by another ‘customer’) to allow for the additional money funds to pay the interest. Thus the Ponzi scheme grows.

  3. Guest   October 3, 2008 at 4:29 am

    The FRB should be abolished. It has become a tool for political agenda’s rather than economical prosperity.Support HR 2755 Abolish this government within the U.S. government.

  4. Nahil   October 3, 2008 at 5:25 am

    The liquidity created out of thin air thro derivatives (designed by Mad Men in banks – Warren Buffert – 2003)vanished into thin air when the Property gear wheel got stuck. Where are all un accounted for an OTC trades (400 Trillion) and counter party obligations going to land – we are in for a Crash – There will be an equalisation/narrowing of standards of living between the developed and developing worlds.USA has to save and pay back what it owes externally and internally.

  5. K.M.Shravan Dharmaraj   October 3, 2008 at 5:54 am

    the bottomline is that fort knox is gonna work overtime printing valueless paper currency to resolve the crisis

  6. Guest   October 3, 2008 at 12:01 pm

    The idea of raising deposit insurance is not to protect any individual bank. It is to draw enough money market fund money into the banking system to compensate for illiquidity in the commercial paper market (which due to backstops end up as bank loans). Did Japan’s interbank loan market freeze up in its crisis? If not, the Japanese experience is not relevant to this particular policy decision.

    • Takeo Hoshi
      Takeo Hoshi   October 3, 2008 at 2:07 pm

      Japan’s interbank loan market (call market) indeed frose up. Japanese banks also had difficulty borrowing in other interbank loan markets (remember Japan premium?). The Bank of Japan provided liquidity into the market by expanding the scope of monetary operation as the FRB has been doing recently. Indeed, the FRB seems to have borrowed the playbook from the BOJ. The BOJ did eventually cut the target interest rate all the way to zero. The FRB is heading the same direction.

      • Guest   October 3, 2008 at 6:10 pm

        I looked up the Japan premium. It appears that Japan was able to borrow at a one year term for a relatively small premium of 1% or less. (I realize that in standard financial terms this appears huge, but interest rate premia that are just high — like those we have seen throughout the summer — should not be classed with interest rate premia that are prohibitive, i.e. well over 2%.)I suspect that there are two important distinctions between the two economies:What fraction of Japan’s equivalent of M2 was in prime money market funds (i.e. money that easily flees from commercial finance to government finance)?What portion of Japanese bank finance relied on rolling over commercial paper?The US simply has to find a way to bring the funds that have run to Treasury money market funds back into the commercial sector.

      • Guest   October 3, 2008 at 7:12 pm

        I think there may be one other crucial difference: The current money market crisis in the US is characterized by a flight from commercial US dollar assets to government US dollar assets. For this reason a bank deposit guarantee may be sufficient to redirect the funds into the US commercial sector. If the situation in Japan was characterized by a flight from the Yen itself, that would be a very different circumstance. It might even point to the possibility that deposit insurance in the US should be raised as quickly as possible — before there is any issue of flight from the dollar.

      • Guest   October 3, 2008 at 9:08 pm

        I’ve gone back and reread your post. Was the deposit insurance policy combined with payment of zero interest deposits? That obviously would be a problem and preclude deposit insurance from being effective.In the US it would be easy to have insured bank CDs paying 3% or more, while Treasury money market accounts pay close to zero. The interest rate differential would then be likely to draw money into bank accounts.

        • Takeo Hoshi
          Takeo Hoshi   October 6, 2008 at 12:31 am

          Thank you for these comments. You are right on most of these points. In terms of size, the Japan premium was smaller than what we have been seeing for the U.S. and European banks in the last couple of weeks. In this aspect, we may be looking at more serious situtation than Japan faced, which suggests we may need to do more than Japan did to deal with the problem.Japan did not experience a flight from the yen. The yen did not depreciate very much. So here, too, the current US situation is different from Japan.

  7. mikmak   October 3, 2008 at 8:11 pm

    “The economy did not grow, but many people maintained their quality of life”. When I went to Japan a few years ago, I was astounded by the high standard of living and the signs of affluence (more widespread affluence than NYC) there even though Japan was supposedly in a recession. So the Japanese drive fewer Ferraris and Lamborighinis nowadays… but they still totter around in Louis Vuitton bags and their (only) one Ferrari or Lamborighini. It didn’t seem like such a bad recession to me. Too bad the quality of life in the US (or at least NYC and San Francisco) is not as nice as Tokyo when we go into our own recession.