Last month, US banking regulators stepped in to guarantee all deposits at Silicon Valley Bank.
They did so both out of a fear of further contagion within the banking system, but also in response to intense lobbying by the technology industry, which had made clear that a huge number of companies would fail to make payroll in the absence of a significant intervention.
Although the regulators have avoided committing to a similar policy should any additional banks fail, much noise has since been made about the potential moral hazard of providing deposit insurance for all bank deposits.
This concern is misplaced, and this panic about moral hazard ignores the serious economic costs of failing to provide adequate deposit insurance.
Let’s take a look at the parties involved.
The depositors. To assume moral hazard on the behalf of the depositor, we’d have to assume that in the absence of comprehensive deposit insurance that people and companies would go to significant lengths to assess the creditworthiness of the banks that they keep their money in.
But banks are extraordinarily complex entities, and most businesses – let alone most people – do not have anything close to the expertise necessary for them to do such an assessment. Should the world’s SMEs all hire experts in assessing the financial strength of their banks? This would be a grotesque tax.
The bank executives. To assume moral hazard on the behalf of the bank executive, we’d have to assume that the absence of comprehensive deposit insurance somehow results in a superior outcome. It doesn’t – banks have failed in spite of this and will continue to do so – usually for the same reasons (weak governance and risk management).
While a given executive might be tempted to increase their bonus by taking on more risk with the knowledge that depositors would ultimately be protected, the cost borne by the individual executive when that bank inevitably fails is already baked in. Running a bank like SVB into the ground is a fairly good way to ensure that one’s career is over. But there is room for improvement here, and the UK has led the way with its Senior Managers Regime providing mechanisms for both individual accountability and the ability to claw back compensation retroactively.
Bank shareholders. To assume moral hazard on the behalf of bank shareholders, we’d need to assume that comprehensive deposit insurance would result in greater degrees of risk-taking by banks in the pursuit of returns. But this, too, is a fallacy, as poorly managed risk always leads to the same result: shareholders getting wiped out.
By contrast, failing to provide comprehensive deposit insurance means that depositors will be highly incentivised to place their cash in only the safest of locations – which, as we’re currently seeing, means in money markets or the world’s biggest banks.
While money markets are by no means bad, shifting a significant percentage of the economy’s savings from bank deposits to money markets has the effect of dramatically constricting the amount of credit available for lending. And while the world’s regulators may want to “cool down” their respective economies now in their fight against inflation, they run the risk of triggering a long-term shift in saving behaviour that will permanently cripple the engine of growth their economies rely on.
Similarly, the conceit that only the largest banks can possibly be safe creates a deeply anticompetitive dynamic which will have the long-term effect of stifling innovation and only increasing the cost of failure when it comes.
The UK’s regulators have a pro-competition mandate, and the current state of deposit insurance (85K for individuals and a very small subset of small businesses) is bad for the banking sector and the UK’s economy as a whole. It needs another look with open eyes.