In recent years there has been a lot of fuss around state guarantees extended to deposit holders in banks. The deposit guarantee schemes vary considerably from country to country, but tend to have a relatively low cap at 25 000€ – 100 000€, and some countries don’t even refund 100% of the money but for instance just 90%.
For details, check out Wikipedia’s article: http://en.wikipedia.org/wiki/Deposit_insurance
This ain’t smart. The state guaranteed deposit insurance scheme should be 100%, unlimited and include a good liquidity guarantee. And yes, it is important.
There are two main reasons why deposit insurance is important. Firstly, there is an important need in the economy for a simple and completely risk free wealth preservation mechanism (that is – a safe bank account). Secondly it is important to avoid bank runs.
A safe bank account: a vital economic cornerstone
The economic need for a risk free way of storing wealth applies to both individuals and organizations such as companies. People have to be able to sell their house and put the money in a bank account while conducting the purchase of the next house without getting ruined if the bank folds over the weekend. Likewise, companies must be able to safely deposit the money they will use to pay salaries and suppliers without going bankrupt just because their banking connection does. For both these groups a limit of 100 000€ is much too small, and there is no reason not to make the guarantee unlimited. A higher limit would make the effect of a bank collapse smaller, but what is the point in allowing very large businesses or wealthy individuals to go bankrupt just because a bank does? It is neither fair nor smart.
Why does it matter if a large company goes bust? Why should the state use taxpayer’s money to protect big business? Firstly, because it would protect these same taxpayers from the risk of unnecessarily losing their savings or jobs. Secondly, the tax take on a company over its lifetime is typically much larger than the bank deposits that would have to be covered (and the benefit to society overall is of course much larger still). Furthermore, when a state backed deposit guarantee isn’t properly in place both companies and individuals will have to put in place other, more expensive but less effective protection mechanisms.
Avoiding bank runs
One of these protection mechanisms is particularly harmful, namely to shun a bank that is rumored to be in risk of defaulting. Since a wholesale withdrawal of funds from any healthy bank will normally be fatal no matter how solid it is, a bank run is the very last thing a shaky bank needs. Also, a bank collapse is a very costly thing for both the bank, its clients and society in general (including the State) so letting a bank that might have survived fail is a big waste of money for everyone involved.
It is worth noting that in order to avoid a bank run depositors must feel certain that they will not suffer any great ill effects of a bank failure that exceeds the efforts required to withdraw the moneys. Given that withdrawing your money only requires queuing at the bank or firing up your PC to access your internet bank account the potential suffering must be very small indeed. Everyone who can expect losing 10% of their deposits, have a few € more than the insurance limit on their accounts or are worried about having their funds frozen will withdraw their deposits.
Don’t just guarantee the deposits – guarantee liquidity too!
This brings us to the final part of the insurance scheme – it must include a good liquidity guarantee. It is very impractical, and potentially very harmful for an economic entity to have its liquid assets (read money) frozen for even a small amount of time. Money is the lifeblood of businesses, and if it stops flowing value creating commerce slows fast. The insurance scheme must be prepared to ensure deposits will be available to its owners quickly after a bank collapse.
So why are there limits to the deposit insurance in the first place? The reasons are chiefly a fear of moral hazard combined with a misplaced wish to save the State’s money. To sort out the wish to save money first: it is bluntly obvious that allowing otherwise successful and tax paying businesses or individuals to collapse for no fault of their own is bad business in the long run for the State. Regarding the issue of moral hazard it is best addressed by the State itself, which is the only entity with a real ability to check and control the behavior of banks. I will address that some other night.