We are developing the social individualist meta-context for the future. From the very serious to the extremely frivolous... lets see what is on the mind of the Samizdata people.

Samizdata, derived from Samizdat /n. - a system of clandestine publication of banned literature in the USSR [Russ.,= self-publishing house]

Samizdata quote of the day

Contrary to what most people had assumed, banking in the United States had been highly stable in the decades before deposit insurance. Of course, depositors were concerned about their safety, but this made them cautious in whom they banked with. They demanded reassurance from their banks, and the banks gave it to them. Pressure from depositors forced the banks to be conservative, to lend carefully, to keep their leverage ratios low, and to disclose their broad positions. The bankers themselves were conservative even in their dress, but this was itself reassuring, and the solid architecture of the banks’ offices reinforced the notion that they were pillars of the community with solid roots in it. The key to banking was maintaining the confidence of depositors and not taking that confidence for granted.

Before deposit insurance, a bank that took too many risks would eventually undo itself. It would do well for a while, increasing market share and generating better shareholder returns than the fuddy-duddy banks, which would feel the pressure. However, come the inevitable downturn, the cowboy bank would experience heavy losses on its questionable lending, liquidity would tighten, and a point would come where the frightened depositors would run for their money: the cowboy would be literally run out of business. These occasional crises were unpleasant, but good for the long-term health and even stability of the system: the runs would expel the cowboys from the system and give a salutary reminder to those who survived. The system itself was rarely seriously at threat, because the depositors would redeposit their funds with the safe banks. There would typically be a flight to quality, a transferring of funds within the system, rather than a run on or threat to the system as a whole. Thus, it was the threat of a run that kept the bankers in line.

Once you introduce deposit insurance the situation changes profoundly. Deposit insurance allows the bankers to take their depositors’ confidence for granted. This takes the pressure off the bankers, who can now safely increase both their lending risks and their leverage ratios, thereby increasing returns to their shareholders (or, in modem Wall Street, to themselves). For their part, the depositors are no longer concerned with the risks their banks are taking, but only with the rates they get on their deposits. Consequently, deposit insurance subsidizes risk-taking, so leading to excess risk-taking with the deposit insurance agency and, ultimately, the taxpayer, picking up the tab.

Nor does the damage end there. With deposit insurance, there is no longer any run to fear and even the most insolvent banks following the most unsound “shoot to the moon” investments can now remain in business indefinitely, attracting more funds and staying in business by merely raising deposit interest rates. The process of competition then becomes utterly subverted: instead of allowing the conservative banks to drive out the cowboys, even if it takes a little time, the process of competition now rewards the cowboys and penalizes the good banks. It therefore pays to become a cowboy and, eventually, all banks do.

- From Alchemists of Loss by Kevin Dowd and Martin Hutchinson (pp. 271-2). Pictures of the two authors here, taken at the launch of the book last Wednesday evening at the Institute of Economic Affairs.

21 comments to Samizdata quote of the day

  • Laird

    What a great summary of the moral hazard presented by government-subsidized deposit insurance. This book is going near the top of my “to-read list” (and I’m going to immediately download the sample onto my Kindle).

  • cubanbob

    This would not be a problem if the depositors were to pay the insurance premium based on the riskiness of the depository bank.

  • Valerie

    Uhm, I may have read/gotten this wrong but when did banks “stay in business by merely raising deposit interest rates”? Greenspan, as I recall, deliberately kept interest rates artificially low to stimulate investment-Thereby penalizing savers, such as myself. While the early 80′s were bad economically, one could at least earn 7-10% on a CD or savings account-something unheard of for the past 20 years if I recall correctly.

  • Paul

    This sounds nice in theory, but if we did not have deposit insurance right now, this crisis would have runs on the bank, paranoia, and misery not seen since 1929.

    I think we need to separate the functions of the bank in our discussions here. One function is a place to put your relatively substantial savings as a very liquid investment. The other function is just to keep your small savings or business operating funds that you need in day to day life.

    Investors can take care of themselves when it comes to risk, but average people just saving a couple of paychecks really should not be subjected to the need to carefully analyze how solvent their bank appears to be. They won’t get it right. It is these non-investors the deposit insurance is really aimed at, and they need it.

  • This sounds nice in theory, but if we did not have deposit insurance right now, this crisis would have runs on the bank, paranoia, and misery not seen since 1929.

    You appear to miss the point entirely… the current system needs ‘runs on the bank’ because without a perception of risk, we end up exactly where we are now.

    It is the notion that the state can magic away all depositor risk that ‘sounds nice in theory’. In reality however it ends up with the sort of systemic mess we see manifested at the moment.

  • William H Stoddard

    You know, it strikes me that the quest for a market where no one ever suffers losses, goes out of business, or gets wiped out financially is a lot like the quest for forests that never burn. The undergrowth piles up and piles up and eventually you get a really catastrophic fire, instead of a small brushfire every year or two. What people don’t get is that it’s the losses and failures that keep the market healthy.

    I understand that immunologists are starting to think that raising children in sterile, germ-free environments gives their immune systems so little to do that they end up getting autoimmune disorders. That seems sort of parallel too. “If we eliminate all bad from life we will have unmixed good!” That’s the faith in opposite values that Nietzsche criticized. . . .

  • Paul Marks

    Banking was “highly stable” in Canada before “deposit insurance” (for example no bank failed in Canada in the Great Depression – and there was no deposit insurance, and no Central Bank in Canada at that time).

    But I do not know of a time when banking has been “highly stable” in the United States – with most States having laws against branch banking (and so on).

    For the first great bank run (in peacetime) see “The Panic of 1819″ by Murry Rothbard.

    I have problems with Rothbard as a general historian – but as an economic historian (and as an historian of economics – not the same thing) he was very good indeed.

  • Paul Marks

    Kevin Dowd has a different perspective an banking from Rothbard (or from me).

    For example, Dr Dowd sees corporate ownership as a problem, and does not seem to see a problem in loans not being from real savings (i.e. so called “fractional reserve” banking).

    I have no problem with a bank being owned by shareholders and it being a limited liability entity AS LONG AS EVERYONE WHO DOES BUSINESS WITH IT KNOWS THAT (i.e. they can see the letters “Ltd” or “Inc” – so they know that the owners will keep their homes and so on even if their investment in the “trading pot”, the bank in this case, is wiped out).

    However, I do have a problem with total loans being greater than total real savings – as that violates a basic law of logic (and violating reason has bad consequences – like spending ten Pounds when you only have nine Pounds).

    However, we agree on “deposit insurance”.

    One can not rationally “insure” against mistakes in business judgment – so “deposit insurance” against bankruptcy (as opposed to against fire, flood, earthquake etc) makes no sense.

    It seems to be based on the false idea that human beings are not agents (are not “beings” at all) and do not make their own judgements – that they are caught up in vast impersonal forces that either by a series of causes and effects (going back to the Big Bang) or by random chance, produce bankruptcy.

    I reject this (unspoken) philosophical assumption (this denial of agency – of free will) so I reject “deposit insurance” as a sensible idea.

  • Paul Marks

    Sorry for a third comment – but I have just noticed what Paul wrote “we need to seperate the functions of bank”.

    I think this is a mistaken way of thinking – a bank is a business, to even think in terms of its “functions” is a mistake.

    A bank offers services – for which it plans to make a profit.

    If one says “I want an institution that just takes care of my money and does not take risks with it” – that is fine, but it is NOT a bank.

    It is a safe deposit establishment (a place that still uses the word “deposit” in its original sense).

    But one PAYS to have ones money looked after there – there is certainly no interest paid.

    How could there be?

    If you want a bank to operate like that – then you would have to accept that you PAID to put your money in (and have it looked after) and you PAID to take money out from an ATM machine. And so on.

    Perhaps you would not pay very much (that would be a matter of competition between banks).

    But the idea of a place where you deposit “a few weeks pay” for nothing (let alone got interest on it) just is not going to work.

    Even if own put “a few pay cheques” (“cheques?” – you are in RISK land right there, if you want no great risks you better be paid in CASH as Henry Ford decided he would pay his employees after the crash of 1929 – and Ford carried on paying in CASH till well after World War II). Milton Friedman though the Ford Motor Company system of payment in cash “inefficient” – which it is, if (like Friedman) you assume that cheques will never be a problem, that banks will never get into trouble, and never go slow or charge for cashing cheques (i.e. you assume the 1930′s, and so on, simply never happened – or can be prevented from happening again by a benevolent government).

    If you want to put a “few payments” in a charitable trust (not an evil profit making bank) – you are still going to have to pay them for looking after the money and paying it to you as you want it.

    They still have costs – and you are still going to have to pay them.

    If you want to avoid risk.

  • Vinegar Joe

    The process of competition then becomes utterly subverted: instead of allowing the conservative banks to drive out the cowboys…..

    Why do Brits have to take the word “cowboy” and turn it into a slur? Do they really such have a problem with hardworking, honest people? Is it more lame-brained anti-americanism or what? Can someone please explain?

  • Jaded Libertarian

    @Vinegar Joe

    I think cowboy became a slur in the US long before Europe. I don’t think it has anything to do with anti-Americanism.

    The cowboys of the original American West were seasonal workers who worked only in the summer months and earned their years wage in that time. They had reputations for spending the winter months in idleness, drinking, fighting, gambling and whoring.

    They were held in low regard by the settled working population of the US. As to how accurate a picture of the cowboys is neither here nor there. Just like it doesn’t matter how cultured the Philistines really were.

    Their names have become bywords for something else.

  • Is it more lame-brained anti-americanism or what? Can someone please explain?

    I seen/heard the same use of cowboy as an epithet used in France, Germany and… New York

  • Vinegar Joe

    I seen/heard the same use of cowboy as an epithet used in France, Germany and… New York

    All centers of libertarian ideals. lol

  • No Joe, that simply is a list of foreign countries. I’m sure California has been omitted because Perry may have not personally seen/heard it there, but a man cannot be everywhere all of the time.

  • Alsadius

    The moral hazard of deposit insurance is real, but making the alternative out to be idyllic is absurd. “People just withdraw their money from bad banks and redeposit it somewhere reliable” sounds great, until you realize that the entire premise of the claim is absurd. If the bank could pay back everyone who wanted their money, it wouldn’t go out of business. If you’re at the beginning of the run, you’re fine, but if you’re in the middle(never mind the end), you’re screwed. Like, “your life savings are gone” screwed. Also, speaking of banks in the decades before deposit insurance being fairly stable is rank absurdity. The year before deposit insurance was created, literally thousands of American banks failed.

    Deposit insurance has flaws, and this quote is right about many of them. But on the whole, it has been far more success than failure. Frankly, it’s one of the few things FDR did right in peacetime.

  • paul

    “This sounds nice in theory, but if we did not have deposit insurance right now, this crisis would have runs on the bank, paranoia, and misery not seen since 1929.

    You appear to miss the point entirely… the current system needs ‘runs on the bank’ because without a perception of risk, we end up exactly where we are now.”

    Perry,

    I did not miss the point. You’re saying the fear of business losses will help discipline the banks and cause them to run their businesses more conservatively, thus leading to a healthier overall banking environment. Am I wrong?

    Again I say this sounds nice in theory, but in practice, at least for America, the banks DID fail in droves. People DID lose their life savings, runs on the banks were going on all the time, fear was everywhere, and it was really, really horrible. I am arguing this is one of those situations where a little government regulation has been very helpful. More government is usually a bad thing, but it isn’t ALWAYS bad, and deposit insurance has turned out to be one of government’s best ideas.

    We do not have runs on the bank in America today. Without deposit insurance, this crisis would most certainly have produced hundreds of runs, and we would be treated to the spectacle of tearful elderly people on TV saying they were wiped out, or people who lost everything and can’t pay their rent moving out into the streets, soup lines…the whole thing all over again.

    The banking system does a lot more than just permit people to collect interest on their deposits. Ordinary people ARE NOT equipped to determine the health of their bank. Without deposit insurance, ordinary people would fear banks and simply stuff their cash in their mattresses. This behavior removes their money from the investment world entirely and leaves us all the poorer.

    I agree with everyone here that government is way too big and does a lot of bad things to offend against liberty and damage the economy. But pure anarchy does not work very well, either, so the trick is to find the right balance. All the basic government functions of protecting us from both domestic and foreign violence, enforcing contracts and adjudicating disputes are necessary and important functions of government. Some regulations (but not many) have proven valuable enough to fall into the “necessary and proper” category, and I think deposit insurance clearly makes the grade.

  • PeterT

    Can we start referring to ‘cowboy’ builders as ‘police’ builders? As in ‘bumbling incompetent reckless’.

    I basically agree with the notion that moral hazard plus idiotic regulations are the cause of the financial crisis. I too deny the notion that people are idiots and so need deposit insurance. Banks are also dependent on the inter bank lending market – so even if Joe Bloggs doesn’t bother looking at the bank’s balance sheet before lending (depositing) his money there, there is a market mechanism for monitoring banks (although this was ruined by governments). If a bank starts getting in trouble then in a free market depositors should be able to sell the bank issued IOU’s that their deposits are at a discount. So it is not an all or nothing scenario. Bank runs can be prevented by a clause that allows the bank to suspend redemptions for some time, or apply penalties on redemptions. Cash (and hedge) funds basically operate along these lines, and having seen it applied in practice during the crisis (I work in investment) I think it works fairly well.

    Worth mentioning that Dowd is also a recognised (at large – not just to us outsiders) expert in mathsy risk modelling as well as a free banking expert. So hopefully his book will be read by some people in the profession.

  • The banking system does a lot more than just permit people to collect interest on their deposits. Ordinary people ARE NOT equipped to determine the health of their bank. Without deposit insurance, ordinary people would fear banks and simply stuff their cash in their mattresses. This behavior removes their money from the investment world entirely and leaves us all the poorer.

    If ordinary people are not equipped to determine the health of their bank, then they are not equipped to determine the health of any institution. It is a dubious premise that ‘ordinary’ people can’t make a reasonable judgment about forces over which they have little direct influence. They do it all the time.

    ‘Leaving us poorer’ by keeping one’s money out of circulation, does not leave us poorer. It denies some the ability to profit from the investment of that money pile, which is not the same thing.

    Even non-ordinary ‘smart’ people do dumb things… we all make mistakes. The trick is to spread your mistakes (and your investments) in a fashion that a few inevitable failures won’t take you down.

  • Laird

    Errors by a couple of Pauls here.

    Paul seems to think that banks failed during the Great Depression due to a lack of deposit isurance. Not so. Runs (and bank failures) were a symptom, not a cause. The Depression was a consequence of gross manipulation of the money supply by the Federal Reserve; deposit insurance (of the sort we have today) would have only made it worse (difficult as that may be to believe). Read Thomas Woods’ Meltdown for a more complete explanation. It’s a short book and well worth the read.

    Paul Marks (once again) argues that deposit insurance is fundamentally illogical because you “can’t insure against mistakes in business judgment”. That’s simply untrue; we do so all the time, in the form of “error and omissions” and “directors and officers liability” insurance, among other forms. The problem is not deposit insurance per se; the problem is command-and-control, one-size-fits-all government-subsidized and -controlled deposit insurance, which is neither competently administered nor actuarially priced. Private deposit insurance would be priced based on the amount of coverage offered (i.e., $10k, $100k, unlimited, whatever) and the underlying risk in the bank’s balance sheet (loan and investment quality, asset-liability mismatches, etc.). An insurance company with a direct pecuniary interest would model that quite carefully, and if it were competing against other such companies there would be external controls on its tendency to be too conservative. Banks would offer the type and amount of insurance they calculate would be most attractive to their customers. If the cost were too high relative to their competitors it would adversely affect the interest they could pay and the rates they would charge, and so would force more careful lending and operational practices. Contrarily, government deposit insurance is not rationally priced, contains every incentive to keep alive “walking dead” banks in the hope that an improved economy would somehow lead to their resurrection, and is an open invitation to political meddling (which is endemic today).

    If the government is to provide some form of deposit insurance it should be for a de minimus amount, such as $10k. There is some societal benefit to not having to worry about tiny amounts. But it should be explicitly and irrevocably limited to that amount, to force depositors to more carefully examine institutions holding larger amounts. It needn’t be done by everyone every time, either; the market will aid in the analysis, via such mechanisms as private rating agencies (similar to Underwriters Laboratories), interest rates demanded by institutional depositors, and even private insurance. The key is to remove the moral hazard of politically-controlled deposit insurance as a key driver of people’s actions (depositors and bankers alike).

  • Paul Marks

    Laird decides to attack what I said on my birthday (the comments by others did not contain arguments – so it is rather hard to reply to them). However, I like attacks (when reasoned) – so it is a good birthday present.

    O.K. Mr Smith offers to insure depositors against bad loans at the bank owned by Mr Jones.

    But Mr Smith demands no control over who Mr Jones lends money to (or on what terms).

    I fully admit that this is “possible”, but I contend it would be a very silly thing for Mr Smith to do (unless he was offering this “insurance” at a rather high price).

    By the way – how much do depositors pay for the government “insurance”? Or is this “insurance” just insurance in name only – i.e., in fact, just another subsidy. Although there is a general government scheme by which banks (in general) are forced to pay into a big WELFARE pot (hardly “insurance” in any commercial sense) to cover banks going bankrupt.

    I.E. (of course) “moral hazard” to an extreme degree – and good (ish) banks being dragged down by ultra bad banks (by forced to pay for them). It must lead to a general collapse over time. Which is why the government (and Federal Reserve) resorted to open subsidy (thus destroyig even the pretence of “insurance”) with TARP and so on.

    As for the government – like all their ventures into business, “deposit insurance” will turn out to be daft. Here I agree with Laird – one size does not fit all (and so on).

    It, therefore, was not one of the sensible acts of FDR.

    “But without it banks would be brought down”.

    Some might be (ones that deserved to be) – but banks that were not an accident-waiting-to-happen would not be.

    After all even the Canadian banks (which were fractional reserve) were NOT bankrupted by the 1930s.

    They had no “deposit insurance scheme” and no central bank either.

  • Paul:

    But Mr Smith demands no control over who Mr Jones lends money to (or on what terms).

    Why this assumption? In other areas of insurance, such as home and vehicle, insurance companies place all kinds of restrictions on the insured that limit the freedom of their actions – why not the same with banks?