Moral Hazard and the Deposit Insurance Cap: A Case Study of Northern Rock and Silicon Valley Bank

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Abstract

The main contention of this article is that government insurance for bank deposits should be unlimited. The topic of bank deposit insurance, particularly in the economics discipline, is frequently associated with some of the more controversial topics of study: moral hazard, free-riding, private liability backstopping and ever-increasing extensions of government safety nets to the financial system. Copious studies purport to “prove” that the incentives created by insuring bank deposits leads to financial fragility, because the guarantees provided by such arrangements lead risk-taking bankers to gamble with cheap sources of funding, whilst simultaneously allowing creditors to shirk their monitoring function.

In this article I argue that these debates are much more convincing in theory than practice. The evidence that monitoring by depositors increases with lower deposit guarantees is not conclusive; indeed, the empirical record demonstrates that the opposite effect is frequently evidenced. I provide convincing empirical evidence that in recent runs on depository institutions – Northern Rock in the UK and SVB in the US – those with most to lose (ie. large depositors with deposit amounts in excess of insurance limits, and uninsured creditors) did not exert discipline upon their debtholders in excess of the wider market, indicating that they failed in their monitoring role.

There is also strong evidence that in developed jurisdictions with established, mature regulatory institutions that deposit insurance does not result in excessive risk-taking on the part of banks. Other than the almost total elimination of the potential for depositor runs, there are a number of financial stability benefits which would accrue from such a reform: current limits on deposit insurance harm competition in the banking system, and the incentives for bank-like financial intermediation services outside both the regulatory and safety nets – so-called shadow banking – would be diminished. Whilst a ‘zero-failiure’ regime is undesirable for a multitude of reasons, the fact that uninsured depositors are rarely subject to any loss during bank failures, means that their claims are already de facto insured.
Original languageEnglish
Pages (from-to)272-297
Number of pages26
JournalLaw and Financial Markets Review
Volume17
Issue number4
Early online date29 Oct 2024
DOIs
Publication statusPublished - 29 Oct 2024

Keywords

  • banking
  • deposit
  • insurance
  • SVB
  • Northern Rock
  • bank run
  • moral hazard

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