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J. Huston McCullochOhio State University

Bank Regulation and Deposit Insurance

The subject of government bank regulation s intimately intertwinedwith that of government deposit insurance. If the government is toinsure bank deposits, it should also have some say in the risks thatinsuredbanksare allowed to take, otherwise it wouldleave itself wideopen to unlimitedpotential losses.John H. Kareken (in this issue) comes close to arguing hat bankswithoutgovernmentdeposit insurancecould provide satisfactorily afetransactionsaccounts. I would go one step furtherand argue that gov-ernmentdeposit insurance is not just unnecessarybut actuallyunde-sirable.Banks that offer transactiondeposits are supposedly subject to aninherent nstabilityproblem that makes them prone to self-realizingdepositor panics. Traditionally, ransactiondeposits are denominatedas a fixed numberof currencyunits, while the assets correspondingothese depositsaremostly finite-term ecurities or commercial oans. Ifdepositorsall wanttheirmoney at once, the banks simply do not haveit. To the extent that their assets are marketable, he banks can sellthem off to meet withdrawalswithonly minimal osses. But if thereis arunon the banking system as a whole, the banks' scramblefor fundscould conceivablydrive interest rates up andasset pricesdown to thepoint at which the banks are actuallyinsolvent simplybecause of de-positorfears thatthey mightfail. To the extent that bank assets consistof poorlymarketable ommercial oans, they are even moreexposedtothe risk of runs. This inherent instability problemis the most com-monlycited argument or governmentdeposit insuranceandthe care-ful governmentregulation t entails (or ought to entail).However, the money marketmutual und(MMMF) s a recent mar-ket innovationthatcompletelysolves this inherent nstabilityproblemof the payments system. As Karekenpointsout in his paper,MMMFs,like all mutual funds, are run proof since their obligations to theirinvestors are simply pro ratasharesin the currentmarketvalue of the(Journal of Business, 1986,vol. 59, no. 1)? 1986by The Universityof Chicago.All rightsreserved.0021-9398/86/5901-0006$0150

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80 Journal of Businessfund'sportfolio. To the extent that depositors/investors ine up at thefrontdoor to take theirmoney out, the rate of return o depositingnewfunds will increase, and new depositors/investorswill line up at theback door to put their money in. As long as the fund sticks to veryshort term instruments (20 days is a common average maturity forexistingMMMFs),fluctuations n the marketvalueof the portfoliowillhardlybe perceptible,andbalances willbe predictableenough to makecheck writing practical.1Money marketmutual und balances like these have performedwellas transactionsbalances throughout he turbulentpast decade. In theearly months of 1983 hey actuallyweathereda runthatdepleted about25% of their assets without a single mishap in spite of their lack ofgovernment deposit insurance.2 Most MMMFs voluntarily restrictcheck writingto large amounts, leaving small checks to commercialbanks subsidized by the Federal Deposit Insurance Corporation(FDIC). In the absence of governmentdeposit insurance, however,one could imaginethat for a suitable fee MMMFswouldbe willingtoprocess checks of any size.One important imitationof MMMFs is that their assets must be sohighly marketablethat there is at all times a clearly defined marketpricefor each one, withonly a small bid-askedspread.This means thatMMMFscould not directlymonetizethe commercial oans that are animportant staple of the traditionalcommercialbank's diet. Illiquidcommercial oans could nevertheless still be monetizedindirectly byMMMFsthrough a two-tier system similar to the one Karekenpro-poses: each existing commercial bank would be split into two firms.The first, as Kareken suggests, would essentially be a finance com-pany, makingilliquidterm loans, financedby issues of its own com-mercialpaperwithcomparablematurity.The second firmwould not bethe modified 100%reserve' bank Karekenproposes but rather an

1. Unfortunately,many MMMFsattempt o emulate raditional anksby engaging npennyrounding, .e., rounding he net sharevalue to the nearestcent perdollar.Thisgives investors, particularlyarge institutionalones, an incentive to withdraw undswhen interest rateshave risen by less than enough to cause a pennychange since thenshares are overvaluedrelative to the shares of funds that do not penny round. Theresulting hortfallwill providean even greater ncentive or withdrawals, ntileitherthepennylimitis hit andthe shares become undervalued, esulting n an instable nfluxoffunds, or the fund'smanagervoluntarilymakesup the shortfall.The latterwas actuallydonefor one penny-roundingunda few years ago, at great expense to its sponsor.2. The run alluded to occurred as depositorsmoved funds into the new moneymarketdeposit accounts (MMDAs)at banksand thrifts, which are guaranteedby theFDICandthe FederalSavingsand Loan InsuranceCorporationFSLIC)againstany lossof presentvalue. AlthoughMMDAs are even safer than MMMFs rom the depositors'pointof view, they are much riskier romthe point of view of the economyas a wholesincethey maybe used to finance oans of very long maturity,verylow liquidity,or veryhigh defaultrisk.

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Bank Regulation 81MMMFholding,interalia, the marketablecommercialpaper of otherbifurcatedcommercialbanks like itself.3

Kareken's proposed 100%reserve banks for transactionsbalancescould in fact be very risky. Note first that Kareken's use of the term100%reserves is at variance with the usual meaningof the expres-sion. Writers like Irving Fisher and Milton Friedmanhave used it torefer to a bank whose transactionsbalances are backed 100%by im-mediately available high-poweredmoney. Kareken uses it to meaninstead a bank whose transactionsdeposits are 100%backed by Trea-sury securities. While it is true that Treasury securitiesare free fromdefaultrisk (at least underthe post-1933paper money standard), heyare still subjectto interest raterisk, and for long-termTreasurybondsthisriskcan be considerable.Note that30-yearTreasurybonds neces-sarily have an even greaterMacaulaydurationand, therefore,an evengreater nterest rate sensitivity thando the 30-yearamortizedmortgageloans that have gutted the net worth of the thrift industryin recentyears. Long-term Treasury-backed zeroes would be even morevolatile.Banks holding 100%reserves in the traditionalsense would be atleast potentially availablein the absence of governmentdeposit insur-ance for those who want complete certainty of present value. How-ever, if these reserves paid no interest, as would be the case underametallic standardor underthe FederalReserve's currentpolicy, bankscould offer no interest on their transactionsdeposits andin fact mightchargea small fee ( negative interest )for their trouble.My guess isthat most depositors would prefer to receive healthy interest on anMMMFaccount and live with the minor inconvenienceof slightlyun-certainpresentvalue ratherthan to hold such accounts.4Diamond and Dybvig (1983)have shown, in an article approvinglycited by Kareken, that, under sufficiently simplifying assumptions,fixed presentvaluedepositswithmandatorygovernmentdepositinsur-ancemaybe Paretosuperior o any voluntarycontractualarrangement

3. There is no reason why these finance companiesreplacing he commercial oanfunctionof commercialbankscould not functionas the managers f the MMMFsreplac-ingthe transactiondeposit function. However, in order o preventa potentialconflictofinterest, it would probablybe necessary to prevent the MMMFfrom buying its ownmanager's ommercialpaperor at least frompurchasing disproportionate mountof it.Note that Karekenerroneouslyasserts that all MMMFs nvest exclusivelyin Treasurybills. A few do so specialize, but most deal primarilyn commercialpaperand bankcertificatesof deposit (CDs).4. If the central bank paid interest on reserves under a 100%reserve system, asproposed,e.g., by Friedman 1959),with a probability f one, the rate paid would eitherbe too high,in which case money would dominateall other nvestments,or else too low,in whichcase MMMFdeposits would begin to dominate he regulatedmoney supply.Finding he right nterestrate to set on reserves undersuch a systemcould be almost asdestabilizing s settinganinterestrate targetrather han a monetarygrowth argetundera conventionalbankingarrangement.

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82 Journal of Businessthe marketmay come up with. Their argument s based on the ten-dency for voluntaryinsuranceprograms o be less than fully efficient(relativeto a full-informationdeal) when important tate variablesareobserved by the insured but not by the insurers.These theoreticalbenefits, however, must be weighed against thefact that noncontractual insurance may easily create externalitieswhere none existed before. The individualtaxpayerswho must ulti-mately bear the costs of government deposit insurance have little in-centive to monitorthe risksany individual nsuredbank is taking. Thebureaucratswho administergovernmentdepositinsurancewill not per-sonally take any losses and are only remotely answerableto the tax-payers who will. The depositors, who are insured, do not care whatrisks are beingtaken with their money. As a result, insured nstitutionsmay be induced to take on risks that are excessive in terms of theirtotal social costs. If the risky investments pay off, the shareholdersand/or managementwill reap the profits. If they fall through,the re-mote taxpayerswill take the losses. If taxpayershad full informationand could organize costlessly, this problemwould not arise. However,the natureof the economic problemis that informationand organiza-tion often are in fact very costly.

Largely as a consequence of the federal deposit insuranceumbrella,banks and thrifts have engagedwith impunity n all mannerof exces-sive risks-foreign exchangespeculation(FranklinNational),specula-tive energyloans (Penn Square), nadequately nvestigated oans (Con-tinentalIllinois),insider oans (the Butcherbanks),uncollectableThirdWorld oans (almost every top ten bank), and so forth.One particularlymischievous risky activity thriftsand, to a lesserextent, banks engage in is maturity transformation,which exposesthemto interest rate risk. In McCulloch(1981b)I show that this activ-ity, which I call misintermediation, can upset the macroeconomicequilibriumof the economy, resultingin a mismatchof the plannedflow of aggregateproductionand consumptionand leadingultimatelyto an aggregateexcess supplyof, or demandfor, currentoutput, thatis, a recession or a boom. In McCulloch(1985),I demonstrate hat thefairvalue of insuranceagainstthis type of risk far exceeds the 8.3 basispoint premium that the FSLIC and the FDIC charge for insuringagainstall types of risk. Since the federal insurersdo not botherto ratethe premiumsthey charge accordingto the risks the insuredinstitu-tionsaretaking,theirinsuranceacts as a subsidy to misintermediation,making t artificiallymore viable than balancedintermediation.In his new book The Gathering Crisis of Federal Deposit Insurance,EdwardJ. Kane estimates that by 1981 the economic value of theassets of insuredsavings and loans (S&Ls) and mutualsavingsbankshad fallen short of their liabilities by approximately$176.6 billion

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Bank Regulation 83(1985, pp. 101-2). Most of these losses were caused by interest ratespeculation-misintermediation-in earlieryears.

By March 1982 (which was even before the status of loans to less-developed countriesbecame apparent),the condition of federallyin-suredinstitutionswas so grim that Congress abandonedall pretensethat the FDIC and the FSLIC were self-supportingcorporationsbypassing a measure (House ConcurrentResolution [HCR] 290, 97thCong., 2d Sess. [1982])placingthe full faithand credit of the UnitedStates behindfederallyinsureddeposits. Todayfederally nsuredde-posits are as safe as the dollar;or, rather,since the Fed will probablyultimatelybe calledon to monetizethe assets of failing nstitutions,the dollaris only as safe as our federallyinsured banks and thrifts.Thanksto federaldeposit insuranceand, in particular, o HCR290,insured depositors have no need to concern themselves about thesafety or riskiness of the particularbank with whichthey do business.One is as good as another, so far as depositors areconcerned.Instead,bank customers must concern themselves, as taxpayers, with thesafety of every bankin the country.Completeelimination of federal deposit insurance,and, therefore,the replacementof federalregulationwith privateregulationby depos-itorsand/orprivate nsurerswould be the ideal solution.However, thisis probablynot in the wings, nor is the division of commercialbanksinto financecompanies and MMMFs.It is thereforepertinentto askwhat less radicalreformsmightbe attemptedwithinthe current nstitu-tionalframework.First, risk-rateddeposit insurance s not as impracticalas Karekenmakes it out to be, at least not for interestrate risk, whichis relativelyeasy to quantify and evaluate. In McCulloch(1985)I show how thismay be done and provide actualestimates for a variety of degrees ofdurationmismatch and capital/assetratios. This would at least elimi-nate the importantproblem of misintermediation.A small degree ofmaturity transformation s probably not significantlyharmful, norwould it be prohibitivelyexpensive with risk-ratedpremiums.Second, the federal deposit insurance agencies should limit theirefforts to protecting he legallyinsureddepositors.In the PennSquarefailure herewas a commendablemove in this direction,butwithCon-tinentalIllinois the FDIC notonlybackslidto its old habitof bailingoutall deposits but actuallybailed out the holdingcompany creditors as

5. By 1983,according o Kane'sfigures, heshortfall f the thriftshadfallento only$86.0billion,andtherehasprobablybeenfurthermprovement incethen.Nevertheless,it surelycontinues o farexceed the dwindling and to anincreasing xtent the artificial)reserves of the FDICand the FSLIC.

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84 Journal of Businesswell, for which there was no excuse or even precedent.6Indeed, thecomptroller of the currency actually announced that the regulatorswould not allowany of the 11largestbanksto fail as a matterof policy.This gives an enormouslyanticompetitiveedge to these large banksrelative to smallerbanks.And third, federaldeposit insuranceshould, at least marginally,bereplacedby private insuranceand/or self-insuranceby depositors. Iwould not bother to reduce the $100,000 limit as Karekensuggests,however.Theflagrantabuse of brokereddeposits shows us that it isall too easy to circumventsuch limits. Rather,federaldeposit insur-ance coverage shouldbe limited to 90 or 95 cents on the dollar (up tothe existing limit). Depositors could then either subscribeto privateinsurance orthe remainder r else self-insure.At the sametime,banksshould be chargedfederal deposit insurancepremiumsonly on thatportion of their deposits that is actually guaranteedby the federalgovernment.Depositors shouldbe allowed to opt out of federaldepositinsuranceentirely in exchange for the somewhat higherrates bankscouldthenaffordto pay. There is no reasonwhy depositors should notbe offered the choice of more than one privatedeposit insurancecar-rier at any given bank.

I do not agree with Karekenthat it has been a mistaketo removeinterestrateceilings. It is truethatthe FDIC'sand the FSLIC'sabilityin the past to tap the cartelprofitsthese ceilingsgeneratedby findingwillingmergerpartners or otherwiseinsolventinstitutionshas helpedkeep the federalinsuranceagencies afloat thus far. However, this hasbeen a very expensive way to provide safe and sound deposits,comparedto the reducedinterest rates that would be paid under ratederegulation with risk-rated premiums.7 Nevertheless, deregulationdoes create aneven moreurgentneed thanexistedbefore for risk-ratedpremiums.Rate deregulationdoes greatly lessen the importanceof one majorcase for federaldeposit insurancethat I have thus far not touchedon,namely,the stabilityof the money supply andtherefore he pricelevel.Manyeconomists areconcernedthat thepossibilityof losses on depos-

6. Therationalecited by Kareken,andwhich wasgiven at the timeby theregulators,for the bailoutof Continental llinoisCorp., namely,that it was necessary in order tohelp banksattractcapital in the future, is fundamentallylawed. As I pointedout in aletter published n the New York Times(September24, 1984), The functionof bankcapitalis to serve as a buffer to protect the FDIC and depositorsagainst osses. Theargumentmade for protectingholdingcompanycreditors s thereforecompletelyfalla-cious if thesefundsare in factnot at riskandthus not servingas capital romthe FDIC'spointof view. Whatautomobile nsurancecompany n its rightmindwould give driverslowerrates if they accepted a $250deductiblebecause it encouragessaferdrivingandreduces claims, and then make a policy of payingthe deductibleanyway in order toinducecustomersto accept it?7. For elaborationon this point, see McCulloch 1981a, p. 247).

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Bank Regulation 85its makesthe bankmultiplier,and, therefore,the money supplyforanygivenvolume of monetarybase, unstable.Economictheory, however,predictsthat deposits payingfully competitiveinterest in fact providezero monetary services at the margin. In a world with completelyderegulateddeposit rates it is the zero-interestmonetarybase ratherthanthe MI or M2 money supply thatwould have the greatest degreeof moneyness. Fluctuations n the latterwould thereforebe of littleor no macroeconomicconsequence.ReferencesDiamond,Douglas W., andDybvig, PhilipH. 1983.Bankruns, depositinsurance,andliquidity.Journal of Political Economy 91 (June):401-19.Friedman,Milton. 1959.A Program for Monetary Stability. Bronx, N.Y.: FordhamUniversityPress.Kane, EdwardJ. 1985. The Gathering Crisis in Federal Deposit Insurance. Cambridge,Mass.: MITPress.Kareken,John H. In this issue. Federalbankregulatorypolicy: A descriptionandsomeobservations.McCulloch, J. Huston. 1981a. Interest rate risk and capitaladequacy for traditionalbanksandfinancialntermediaries.n ShermanJ. Maisel,Risk and Capital Adequacyin Commercial Banks. Chicago:Universityof ChicagoPress.McCulloch,J. Huston. 1981b.Misintermediationndmacroeconomicluctuations. our-

nal of Monetary Economics 8, no. 1 (July): 103-15.McCulloch,J. Huston. 1985. Interest-risk ensitive deposit insurancepremia: StableACHestimates.Journal of Banking and Finance 9, no. 1 (March):137-56.