Deposit Insurance Chicago

8/9/2019 Deposit Insurance Chicago

1/15

Banking Theory, Deposit Insurance, and Bank RegulationAuthor(s): Douglas W. Diamond and Philip H. DybvigSource: The Journal of Business, Vol. 59, No. 1 (Jan., 1986), pp. 55-68Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/2352687

Accessed: 16/10/2008 10:02

Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at

http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless

you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and youmay use content in the JSTOR archive only for your personal, non-commercial use.

Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at

http://www.jstor.org/action/showPublisher?publisherCode=ucpress.

Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed

page of such transmission.

JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the

scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that

promotes the discovery and use of these resources. For more information about JSTOR, please contact [email protected].

The University of Chicago Press is collaborating with JSTOR to digitize, preserve and extend access to The

Journal of Business.

http://www.jstor.org
http://www.jstor.org/stable/2352687?origin=JSTOR-pdfhttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/action/showPublisher?publisherCode=ucpresshttp://www.jstor.org/action/showPublisher?publisherCode=ucpresshttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/stable/2352687?origin=JSTOR-pdf


2/15

Douglas W. DiamondUniversity of Chicago

Philip H. DybvigYale School of Management

Banking Theory, Deposit Insurance,and Bank Regulation*

I. IntroductionThelast severalyears have seen extensive changein the U.S. bankingindustry. In the 1950sand 1960sthe banking ndustrywas a symbolofstability.By contrast,recentyearshave seen the greatestfrequencyofbankfailures since the GreatDepression.Duringthe sameperiod, thebankingenvironmenthas undergone he most significant hangessince1933, when the Glass-SteagallAct laid down the ideas underlying hemodernregulatoryenvironment.Therecentchangesinclude new com-petitors to banks, new technology, new floating rate contracts, in-creases in interstatebanking,and various regulatoryreductions andchanges. Some of these changes are acceleratedby the currenthighrate of bankfailure;many of the changesaredrivenby technologyandcompetitionand are inevitable. One implicationof all these changesisthat we now face policy decisions that will affect the future course ofthe banking ndustry.Since the currentenvironment s largely outsideour past experience, we need theory to extrapolatefrompast experi-ence to our current situation. The purpose of this paper is to sum-marize the policy implications of existing economic models of thebankingindustryand to examine some currentrecommendations nlight of the theory. Our conclusions contrast with the traditionalviewin economics andwith severalconclusionsin Kareken's(in this issue)lead piece in this symposium.Most references to banks in the microeconomics iteraturehave notlooked at bankingat the industry evel. The bankmanagement itera-

* The authors would like to thank JonathanIngersoll, Charles Jacklin, BurtonMalkiel,MertonMiller,and KathleenPedicini or usefulcomments.Diamondgratefullyacknowledges inancial upport roma Batterymarch ellowshipandfrom he Center orResearch n SecurityPrices at the Universityof Chicago.1. When we discuss the banking ndustry,we includethrifts(savingsand loans) aswell as commercialbanks.(Journal of Business, 1986, vol. 59, no. 1)? 1986 by The University of Chicago. All rights reserved.0021-939818615901-0002$0.50

55


3/15

56 Journal of Businessture has considered the managementproblems faced by individualbankers.Thisliterature s of pragmaticvalue to practitionersbut is notflexible enoughto evaluate policy changes since it takes as given theexistingbankingenvironment.The macroeconomics iterature,on the other hand, has focused onbanks' effects on the macroeconomy,with special emphasison theirrole in determining he money supply.The banking ndustry's nvolve-mentin the money supplyprocess is obviously animportant onsidera-tion in bankregulatorypolicy. However, regulatorypolicy motivatedonly by macroeconomicgoals may destroy banksby preventing hemfromprovidingthe services that are the raisond'etre of banks. Someregulatorypoliciesbased solely on macroeconomicgoalsgo so far as tosuggestimplicitly hat we have no need for banks at all sincebanks canbe replaced by other existing institutions (e.g., mutualfunds). Onepurpose of this paper is to illustratethe danger of this position.A third literaturefocuses directly on the bankingindustryand, inparticular,on the services providedby banks.This literature s in thespiritunderlyingsome of the recent deregulation e.g., the removal ofRegulation Q or the move toward interstate banking), which ismotivatedby a desire to improvethe overallwelfare of bankcustomersby makingbanksmore competitive.Insteadof relyingon generaleco-nomic notions, such as efficiency of competition,the recent literaturefocuses on a more detailedunderlyinganalysis of the services offeredby banks,at a level similar o the level of analysisused by economiststo derive conditions underwhich competition is efficient. Since thisliterature is still young, the models have had limited empiricalverificationandcannot yet leadus to a specificregulatory trategy.Theliteraturehas, however, generated some important deas. These ideasdemonstratethat some of the currentlyproposedpolicies are flawedand may have an effect opposite of what is intended.Here are some policy implicationsof our observations.

1. Proposals to impose marketdisciplineon banks by limitingde-posit insurance or requiringbanks to have uninsured subor-dinatedshort-termdebt are badpolicy. Theseproposalswould beineffective in changing bank behavior and would destabilizebanks, thus reducing the effectiveness of deposit insurance inpreventingruns.2. Banks should be preventedfrom using insureddeposits to fundentryinto new lines of business, such as investing nreal estate orunderwriting quity issues, that are characterizedby risk takingand not primarilyby creation of liquidity.Permittingunlimitedentry into these lines of business undermines he viabilityof de-posit insurance,which is perhapsour only effective tool for pre-ventingbankruns.


4/15

Banking Theory 573. Proposals to move toward 100%reserve bankingwould preventbanksfrom fulfilling heir primary unctionof creating iquidity.

Since banks are an importantpart of the infrastructuren theeconomy, this is at best a risky move andat worst could reducestabilitybecause new firmsthatmove in to fillthe vacuum eft bybanksmay inherit the problemof runs.4. Deposit insurancepremiumsshouldbe based on the riskinessofthe bank's loan portfolio to the extent that the riskiness can beobserved. Whilethis policy cannotpreventbanks fromtakingontoo much risk, it could reduce the incentive to do so. For ex-ample, the deposit insurancepremiumshould be increasedforbanks with many nonperformingoans, banks that have previ-ously underestimated oan losses, and banks paying markedlyabove-marketstated rates to raise money.

These are some of our mainpolicy conclusions;other commentsap-pearthroughout he paper.To understand he services providedby banks, it is useful to startwith a typical bank's accounting balance sheet. We will take asimplifiedview of the balance sheet so that we can understandbankservices at a basic level.2 Deposits are the bank'sprincipal iability. Afew banks(primarilyargemoneymarketbanks)also have a significantnet liability to other banks in federal funds ("fed funds"). (The fedfunds market is the market in overnightloans between banks.) Theother main entry on the liabilityside of the balance sheet is owners'equity.Loans are the bank'sprincipalasset. Almost allbanks,except a fewof the largest (the money marketbanks that are net borrowers),alsolend money to other banks throughthe fed funds market.3Reserves,namely, vault cash and non-interest-bearing eposits, are another im-portantentry on the asset side of bankbalancesheets.Themainfunctionsof bankscanbe described nterms of the balancesheet items describedabove. Asset services are provided to the "is-suers" of bankassets (the borrowers); hese services include evaluat-ing, granting,and monitoring oans. Liabilityservices are providedtothe "holders" of bank liabilities (the depositors);these services in-cludeholdingdeposits, clearing ransactions,maintaining n inventoryof currency, and service flows arisingfrom conventions that certain2. One important part of the bank we are ignoring is the government securities port-folio. Currently, such a portfolio can and should be financed using repurchase agree-ments (repos) and other sources of funds not treated like deposits (i.e., not requiringreserves [see Stigum 1983]).3. As an aside, the existence of the fed funds market calls into question the self-serving arguments of small banks that the entry of large out-of-state banks into theirmarkets would cause funds to flow out of the community.


5/15

58 Journal of Business

liabilitiesare acceptable as paymentsfor goods. Transformation er-vices require no explicit service provisionto borrowersor depositorsbut insteadinvolve providing he depositorswith a patternof returnsthat is differentfrom (andpreferable o) what depositorscould obtainby holdingthe assets directly and tradingthem in a competitive ex-changemarket.Explicitly, this means the conversionof illiquid oansinto liquiddeposits or, more generally,the creationof liquidity.The fed funds market s the market or liquidfundswithinthe bank-ing industry.Generallysmall "deposit-rich"banks have more fundsthanaredemandedby theircustomers,andthe excess fundsare lenttothe generally arge"deposit-poor"banks. The largebankslend out themoneythey borrow.Since the loans of largebanksare illiquidandthefed fundsthey borroware liquid(they can be convertedto cash at fullvalueon one day's notice), the largebanksare performinghe transfor-mationservice. In this operationthe small banksare not performingatransformationervice since they are "converting" iquid oans (infedfunds)into liquiddeposits. The priceof liquidity n the banking ndus-tryis reflected n the interestratein the fed funds market.Whilethefedfunds marketis effective in facilitating he sharingof liquiditywithinthe bankingindustry, it is importantto recognize its limitations.Inparticular, he fed funds market cannot absorb economy-widerisk orprovideinsurancefor bankswhose fundamental oundnessis in ques-tion.In SectionII we give our own admittedlybiasedperspectiveon someof the important deas in the existingacademicliteratureon the bank-ing industry, with a discussion of some of the more obvious policyimplicationsof the ideas. In Section III we use these ideas to give adetailed examinationof two policy proposals (100%reserve bankingandusing market disciplineon large incompletely nsureddeposits orsubordinatedshort-termdebt). We conclude that both proposals aredangerous.Section IV closes the paper.II. Synthesis of Banking Theory and PolicyAsset ServicesExistingmodels of asset services focus on the role of banks' informa-tion gathering n the lendingprocess. What is particularlymportant sinformationthat cannot easily be made public.4This includes bothinformationgatheredwhile evaluating he loan (to limit adverseselec-tion) and informationgathered n monitoring he borroweraftera loan

4. The ideas discussed in the text conform most nearly with Diamond (1984). Severalpapers extend this approach under alternative private information structures, and wedraw on some of these results as well. See Ramakrishnan and Thakor (1984) and Boydand Prescott (1985).


6/15

Banking Theory 59is made (to limit moral hazard).In these models, gettinga loan from abank dominates a public debt offering when the cost to the p-ublic fevaluatingand monitoring he borrower s high. Gettinga loan fromabank dominates borrowing from an individual because bank lendingcan keep both risk-sharing(diversification) costs and information(evaluationand monitoring)costs low.If there were many smallinvestors, there would be duplication andfree riding) in the gathering of information, and there would beinsufficientmonitoring o upholdthe value of the loan. The centraliza-tion of ownershipand informationcollection to a diversified inancialintermediaryprovides a real service, and because of the privateinfor-mation,the intermediary ssets are "special" in the sense that they arenot traded n marketsandarethus illiquid.One interestingresultof theanalysisis that, because the intermediary'snformations private,theprovision of incentives for a bank implies that the claims (deposits)outsiders hold on the bank optimally do not depend on the bank'sprivate informationabout performanceof the loan portfoliosince thebank cannot crediblybe expected to be unbiased n their reportingofsuch information.This precludesthe possibility of an equity-likecon-tract when the bank itself is "making the market"in its own asset,which it must do when partof what the bank is providing s liquidity.5Therefore his theorycan be used to provide one possiblelink betweenasset services and the liability side.In deciding how to regulatebanks, it is important o consider theeffect on the provisionof asset services. In other words, we want tochoose a regulatorypolicy that will give banks the incentive to giveloans to profitableprojects, to deny loans to unprofitable rojects,andto perform the optimal level of monitoring. (We should also be con-cerned about the effect on competition and the pricingof the assetservices. We will not focus on this issue.) For example, if a bank'sliabilities are deposits insured with fixed-rate Federal Deposit Insur-ance Corporation FDIC)deposit insurance,it is well-knownthat thebankmayhave an incentive to select very riskyassets since the depositinsurersbear the brunt of downside risk but the bank owners get thebenefit of the upside risk.6 Since fixed-rateinsurance is necessarilyunderpriced or banks taking large enough risks, banks can have anincentive to pay above-market ates of return o attract arge quantitiesof depositsto scale uptheir investment n riskyassets. If therewerenoregulation,muchof the riskinthe entire economy would be transferredto the governmentvia deposit insurance.(Whyshouldthe government

5. Loans to firms with credit ratings near AAA involve few asset services, and in factthere are active secondary markets for such loans. In this section we refer to the moni-toring of loans to firms with lower credit ratings.6. This point is made forcefully by Kareken and Wallace (1978). See also Dothan andWilliams (1980).


7/15

60 Journal of Business

insure deposits at all? We will addressthis questionin the section ontransformationervices.)There are manypotential solutionsto the problemof banksgrantingloans that are too risky. These solutionsrun parallelto private-sectorsolutionsto similarmoralhazardproblems.7If there is a good reasonfor the governmentto be in the deposit insurancebusiness, there is agoodreasonfor its regulators o bejust as active as theirprivate-sectorcounterparts.One solutionis to imposerestrictionson what banks cando. This solution is essentially like restrictivecovenants includedinbond contracts. Another solution is to make the insurance premiumsvariable,just as insurancecompanies charge lower health insurance

premiumsto nonsmokersthan to smokers and lower auto insurancepremiums o people who have had no accidents.A third solutionis tomonitor the banks continually and to make suggestions on how toreduce risk, just as insurancecompanies do for commericalfire andaccident insurance. These three solutions are closely related,and wesee no compellingreason to pick only one approach.Anotherprivatesectorsolution s the threatof loss of business due to loss of reputation.This solution is inconsistent with fixed-rate deposit insurance sincedeposit insurance ensures that even banks with unsound loan port-folios can raise deposits, and the fixed rate means that not even thedeposit insurance costs can rise.The riskinessof loan portfoliosis a critical ssue. Most of the recentbank failureswere related, in part, to banks holdingrisky loans thatwent into default. Furthermore,many of the banks were actively andrapidly expandingtheir deposit bases to finance the risky loans. Inprinciplebankfailuresmay seem no worsethan otherbusinessfailures,but in fact bank failures can do substantialdamagein terms of inter-ruptingprofitable nvestment by bank customers. In dealingwith theriskiness of loan portfolios, bank regulatorshave focused on restric-tions on bank behaviorand carefulmonitoringof banksbut have beenresistant to introducinga risk adjustmentto deposit insurance pre-miums. There are several practicalreasons why risk-sensitiveinsur-ance premiumswouldbe difficult o implement,especiallyfor govern-ment.It is hardto get good information boutthe qualityof those bankloans for which there is no secondarymarket, et alone objectiveinfor-mation that could justify a governmentalpolicy choice.8 In spite of

7. For an illuminating discussion of the lessons about proper bank regulation that onecan learn by examining how credit contracts are written and enforced in the privatesector, see Black, Miller, and Posner (1978).8. Since a government agency is legally required to be concerned about fairness, it canhave only minimal discretion over apparently healthy banks and must rely instead onobjective information. In addition, it is doubtful that the government could reliablycollect large amounts of subjective information. A private deposit insurance companywould not be so constrained from using discretion and subjective ex ante information butwould leave the banks subject to runs if it lost its credibility, unless itself insured by thegovernment.


8/15

Banking Theory 61these practical problems, some movement in the direction of risk-adjusted nsurance premiums (and other aspects of regulation)basedon objective information,while not a cure-all, would improve the in-centive structure.One example of objective information hat would be useful in regula-tion or insurancepricing s the interest rates paid on deposits, particu-larly if the rates exceed Treasury security rates for a given maturity.There is even a good case to be made for limiting nterest paymentstothe level of Treasurysecurities since insureddeposits are almost Trea-sury securities themselves, with an additional convenience serviceflow.Another potentiallyuseful variable s the interest rate chargedonloans. In each case, high rates are indicativeof high risk, although heymightalso be consequences of high costs associated with a given loanor deposit or of rents. Since it is difficult to penalize banks who dopoorlyex post (becausetheirresourcesarealreadydepleted),these exante variables have some promisein controllingrisk. These schemeswill require careful execution, as the true interest rate may be hard toobserve because of tie-in sales of other bank services: recall all thecreative techniques (e.g., giveaways and compensatingbalance re-quirements)used by banks to circumvent oan and deposit interestrateceilings in the last decade.The riskiness of bank assets is the crucial issue in anotherpolicyquestion, namely, whether banks should be allowed into otherlines ofbusiness. One argument n favor of such a move is that, since otherinstitutions are going into some bank lines (especially in transactionclearing),it is only fair for banks to be admitted nto their lines. Cur-rently, there is pressure and some movementtowardallowingbankstoentersuch lines of business as underwriting tock issues andspeculat-inginrealestate. Theproblem s that all these lines of businessgive thebankopportunities o use insureddeposits to take on largeamountsofrisk that is not easily observedandto circumventany of the policies tolimit risk discussed above. Thereforedeposit insuranceends up insur-ing risky lines of business unrelatedto the bank's primary unctions.Whileit is difficultto insulatedeposits and the deposit insurance undfrom the risks of holding company subsidiaries,this must be done ifentry into new and risky lines of business is to be allowed.Liability ServicesTheclearingof transactionsand the holdingof currency nventoriesarethe most importantbank services associated with the liabilityside ofthe balance sheet. Traditionally,macroeconomists have focused onliabilityservices because of the linkagebetween demanddeposits andthe money supply.9 Money marketfunds, brokers'asset management

9. For example, the monetaryapproachof Fisher(1911)assumesthat bankassets arenot any different hantradedassets, butbank iabilitiesare specialbecausethey serve as


9/15

62 Journal of Businessaccounts, and credit cards have competed more or less directly withthe banks in the marketfor provision of secure and liquid stores offundsand in the market or clearing ransactions.These changes in thepaymentstechnology have weakenedthe linkbetween the money sup-ply and bank deposits. This fact has two types of implications formacroeconomics.One is that banksneed not be so important o mac-roeconomics as they were before since close substitutes exist in theprovision of payment and other liabilityservices. The other (antithet-ical)implication s a potentialpolicy goal of tryingto repair he moneysupply inkageby tighteningbankregulationand keepingnonbanksoutof the liabilityservice businesses.

The importantobservationl s that, even if banks were no longerneededfor liabilityservicesand if they wereconstrained romperform-ing their role in controllingthe money supply, then importantpolicyquestionsconcerningbankswouldstill arise since banksprovide otherimportant ervices. In otherwords, the banking ystem is an importantpartof the infrastructuren our economy.Transformation ServicesConverting lliquidassets into liquidassets is the bank service associ-ated with both sides of the balance sheet. This transformation erviceis the most subtle andprobably he most important unction of banks.It is hardto model andunderstand ransformation ervices because wecannotsimplifyouranalysisby lookingat one side of the balance sheetin isolation. Conversionof illiquidclaims into liquidclaims is relatedto, butnotthe sameas, the "lawof largenumbers"propertyof averag-ing out the withdrawalsof largenumbersof individualdepositors, al-lowing the transfer of ownership without transferringthe loan-monitoring ask.10It is also related to the fact that risk sharingcan beimprovedif we allow such withdrawalsat prices differentfrom whatwould arise with a competitive secondary market in claims on thebank.The recent literatureon transformation ervices shows that there isan intimate relationamongimprovingrisk sharing,fixed claimdepos-money. We can also think of intermediary liabilities as imperfect substitutes for mone-tary assets. See Gurley and Shaw (1960), Tobin (1963), Tobin and Brainard (1963), andFama (1980).10. One can think of publicly owned corporations as providing this "law of largenumbers" service by holding illiquid physical capital. The important distinction withbanks is that bank assets are similarly illiquid, yet their composition can be changedquickly relative to the physical capital of a nonfinancial corporation. Ability to changeasset composition quickly explains the larger moral hazard problem faced by banks. Thisargument applies equally to many other financial institutions: the ability to change thecomposition of assets quickly and secretly was definitely a factor in many recent failuresof government security dealers.


10/15

Banking Theory 63its, and bank runs.1"Specifically, this literatureshows thatbank runscan be a consequence of rationalbehaviorby depositorsandthat runscan occur even in a healthy bank. All that is required o make a runpossible is thatthe liquidationvalue of the loan portfolio s less than thevalue of the liquiddeposits. This is precisely what is needed if banksare to provide liquiditysince the value of liquidity s in the ability tocash in one's assets early without sacrificing oo much value. Socially,we can view the value of liquidityas an improvement n risk sharing-the increased flexibilityfavors the people who are worst off, namely,those who have an urgent need to withdrawtheir funds before theassets mature.

The newly demonstratedtie between the creationof liquidityandbank runs is in contrast to traditional heory. By definition,bank runsare caused by depositors tryingto get out to avoid a loss of capital.Under the traditional heory, runs are set off by expectations of re-duced value of the bank assets, which might happen, for example,when deposits and loans are fixed nominalclaims and when unantic-ipated deflation causes higherthan expected loan losses. Higherloanlosses lead to more bank failures and decrease the money supply,adding o unanticipateddeflation.This cycle feeds on itself if the mone-tary authority does not react appropriately.12 This traditional heorymaybe an importantcomponentof runs, but its validity as a completedescriptionof runs appears to be contradictedby recent empiricalevidence from the Great Depression.13 It also does not explain theexistence of fixed short-termnominalclaims in the firstplace: slightlymore complicated claims could avert runs and improveefficiency ofrisk sharingat the same time.The recent literatureon transformation ervices shows thatthe exis-tence of bank runs does not requireany loss in value of the underlyingassets. Even without exogenous fluctuationsin the real or nominalvalue of bankassets, runscan occur since the cost of liquidating ssetscan make a runself-fulfilling. f there are other reasons for runs(suchas exogenously riskyassets and fixed debt liabilities),providing rans-formationservices impliesthat such runs have social costs. Given theobviousimportanceof these other reasonsforruns, policiesto avoid orminimizethe costs of runs are worth considering.The theoretical iterature ocuses on severalclosely related solutionsto bankruns, all of which have been used in practice. Deposit insur-ance, lending from the governmentto cover large withdrawals(the

11. Our discussion of transformation services is based on Diamond and Dybvig (1983)and important extensions by Jacklin (1983a, 1983b) and Haubrich (1985). For a some-what different viewpoint, see Bryant (1980).12. For the deflation description of runs, see Fisher (1911), and for a description of theconsequent monetary problems, Friedman and Schwartz (1963).13. See Bernanke 1983.


11/15

64 Journal of Business"discountwindow"), and suspension of convertibilityof deposits intocurrencyare three ways to stop or avert runs. In each case, the solu-tion removes the incentives for the depositors to take out their funds.Deposit insurance ensures that depositors will be madewhole even ifthere is a run;the discount windowandthe suspensionof convertibilityboth ensure that the loan portfolio need not be liquidatedat unfavor-able terms. Each of the solutions, if doubted, could again ead to a run.Suspensionof convertibilityprovides only temporary elief, not a solu-tion to runs, unless there is a crediblecommitment o tie up depositors'assets for an unreasonably ong time (until the bank's assets mature).In the recent runs on Ohio savingsandloans, depositorsranon banksbecause they lost confidencein the abilityof a privatedeposit insurerto pay off on deposit insurance claims. Similarly,if the fed does nothave a firmcommitment to lend at the discount window, then therecould be a run if depositorsdoubtedthe fed's intentionto lend funds,as couldplausiblybe the case on discovery (or rumor)of negligencebybank managers. On a related note, one aspect of the ContinentalIl-linois failure exhibited the worst of both worlds: the governmentpaidoff all the large deposits, but since they did not crediblypromiseto doso in advance, they did not prevent a run. In other words, they in-curredthe expense of deposit insurancewithoutthe benefits.To summarize, he recent literature uggestsseveralimportantdeasthat should be consideredwhen evaluatingany policy proposalfor thebanking ndustry.

1. Banksare subject to runsbecause of the transformation ervicesthey offer.2. Bank runs do real damagebecause of the interruptionof profit-able investments.3. Federally sponsored deposit insurance has been the most (theonly?) effective device for preventingruns. Privately providedinsurance and the discount window have not been crediblesources of confidence to depositors. Suspensionof convertibilityinterruptsbankservices andonly defers the problemuntil banksreopen.4. Bankingpolicy mustpreservethe basic functionof banks,thatis,the creationof liquidity.In particular,any device to preventrunsmust not simultaneouslypreventbanks fromproducing iquidity.5. The bank-runproblemis exacerbatedwhen banks can take onarbitrarilyrisky projects. Given deposit insurance (or the dis-count window or suspensionof convertibility), t is important okeep banks out of risky outside businesses.III. Existing Proposals for ReformIn Section II we discussed some basic ideas from the economic litera-ture on bankingand some policy implicationsof those ideas. In this


12/15

Banking Theory 65section we use the same ideas to give a more detailed analysisof twoparticularpolicy proposals. See Kareken (in this issue) for some op-posing views on these proposals.One Hundred Percent Reserve BankingOne proposal is to impose a 100%reserve requirement, hat is, a re-quirement hat intermediariesoffering demanddeposits can hold onlyliquid governmentclaims or securities, for example, Treasurybills orFederal Reserve Bank deposits (which might pay interest). This pro-posal specificallyrestrictsbanks fromentering he transformation usi-ness (they cannot hold illiquid assets to transform nto liquid assets),andthereforethe proposal precludesbanks fromperformingheir dis-tinguishing unction. If successful, this policy would remove the purelymonetarycauses of bank runs by limitingbanks to performing iabilityservices. The net effect of sucha policy is to dividethe banking ndus-try into two parts. The regulated part of the industrywould still becalled banks but would be effectively limited to providing iability sideservices. The other part of the industrywouldbe anunregulatedndus-try of creative firms exploitingdemand or the transformation ervicespreviously provided by banks but that banks could no longer supplyunder 100%reserves. Even if banks would still be viable without therents to providing he transformation ervice, the proposal wouldjustpass along the instability problem to their successors in the inter-mediarybusiness. The instabilityproblemarises fromthe financingofilliquidassets with short-term ixed claims (which need not be mone-taryor demanddeposits). 4 Existing open-end mutual unds (and espe-cially money marketfunds)are essentially 100%reserve banks. Theyissue readily cashable liquid claims, but, unlike existing banks, theyhold liquid assets, as would 100% reserve banks. The mutual fundclaims are cashable at a well-definednet asset value. They providethe"law of large numbers" service, and to some extent they providetransaction clearing services.15 Given the success and stability ofmutual unds, it is tempting o conclude incorrectly hatthey would bea good substitute for banks. Of course, this incorrect conclusion ig-nores the value of the transformation ervices (creationof liquidity)providedby banks.16If banks adoptedthis structure,who would hold the illiquidassets(loans) currentlyheld by banks? If some other type of intermediary

14. Recall that the runon ContinentalBankinvolveduninsured hortmaturity imedeposits.15. Net asset valueis essentiallythe liquidating alueof assets, so they shouldnot besubjectto runs. The few runs on mutualfunds have occurredbecause of a failure toadjustnet asset value to reflect truemarketvalue.16. Orthis conclusioncould be based on an assumption hattherewould be enoughliquidityntheeconomy even withoutbanks.Thisassumption eemsunlikely o be valid,and n any case it would be recklessto baseanextremepolicychange ike 100% eservebankingon this sortof unsupported ssumption.


13/15

66 Journal of Businessprovidestransformation ervices, the other intermediarywould be sub-ject to the same instabilityproblemsas banks. If the replacement nter-mediary provided no transformation ervices, it might resemble cur-rent venture capital firms. Venture capital firms hold very illiquidassets and have liabilities that are equally illiquid, namely, equityclaims and long-term (private placement)debt. There is insufficientinformation bout asset value for a liquid, open-endedstructure.Simi-larly, the replacement ntermediarieswho hold currentthe illiquid as-sets of banks will offerilliquidclaims unless they perform he transfor-mation service.Commercialbanks are an importantpart of the economy's infra-structure.A drastic change like 100%reserve bankingwould affecteven borrowerswho currentlydo not appear o be dependenton banksfor liquidity. For example, almost all corporations ssuingcommercialpaper o raise short-term ash obtainbackup ines of creditfrom banks.The line of credit gives the corporationsan emergencysource of fundsto circumventa potential liquiditycrisis that could prevent themfromrollingover theircommercialpaper.If the replacement ntermediariesdid not take on fixed claims, such as lines of credit, the workingsandliquidityof the commercialpapermarketcould be changedprofoundly.Firmsthat issue substantialquantitiesof commercialpaper would besubjectto runs (liquiditycrises) when they triedto roll it over. Simi-larly, existing moneymarket undsthemselves use banks as sources ofliquidity: heirassets often includelarge quantitiesof bank certificatesof deposit (CDs).Offeringbinding ines of creditthat arenot fully collateralizedby theliquidationvalue of assets is one way of providing he transformationservice "through he back door" since, fromthe customer'sperspec-tive, holding lliquidassets but havingaccess to a binding ine of creditis functionallyequivalent o holding iquidassets like demanddeposits.Just like banks, providersof this transformation ervice are subjecttoruns:the holders of lines of creditmaydrawdowntheirlines in antici-pationif they believe others will do the same.In conclusion, 100%reserve banking is a dangerousproposal thatwould do substantialdamageto the economy by reducingthe overallamount of liquidity. Furthermore, he proposalis likely to be ineffec-tive in increasing stability since it will be impossible to control theinstitutions hat will enter in the vacuum eft when bankscan no longercreateliquidity.Fortunately, he politicalrealitiesmake t unlikelythatthis radical and imprudentproposalwill be adopted.Competitive Discipline: Subordinated Short-Term Debtor Limiting Deposit InsuranceA requirementthat banks issue some minimum fraction of theirliabilitiesas uninsured hort-termdebt is essentiallya requirementhat


14/15

Banking Theory 67some "deposits" be uninsured.This is similarto setting some upperlimiton depositinsurance.Theargument iven in favor of this proposalis relatedto the usual one forusing deductibles n insurance.The morerisk the bankpays for (from facingmarketpricingof its deposits), themore concernedit will be with efficient risk choice and cost minimiza-tion. An implicitassumption s that less depositinsurance eads to lessrisk to the deposit insurancefund and only a little more risk to thebank. Because the owner of a deposit faces a very low cost of with-drawal, even a small chance of a loss can cause a run because theuninsureddeposits arejuniorto the insureddeposits. If the fractionofuninsured short-termdeposits is large, such a run will be costly. Inaddition,as recent experiencehas demonstrated, he governmenthas ahardtime leaving claims on largebanks uninsured,ex post. Explicitlyinsuringsuch deposits can reduce the cost of a run. If the amount ofdeposit insuranceis to be varied, there is a much stronger case for100%deposit insurancethan for limitinginsurance, especially if thealternative s for regulatorsto retain their discretionto in fact insuremost "uninsureddeposits."Requiringbanks to issue some minimum quantity of uninsuredclaims is a good idea, but the requirementought to be to issue long-term claims, such as equity or long-termdebt. Even the usefulnessoflong-termdebt is in question given current law, as illustratedby theway many long-termdebt holdersin ContinentalBank's holdingcom-pany arebeing paid off in full, due to regulator'sneed to avoidencum-bering awsuits.IV. Summary and ConclusionsIn summary, banks performvaluable services. Any complete bankpolicyhas to preventcostly bankrunswhile allowingbanksto continueprovision of their various services. The transformationservice ofcreating liquidityseems to be providedalmost exclusively by banks,and, consequently,it is particularlymportant o preservethe abilityofbanksto createliquidity.Deposit insurance s theonly knowneffectivemeasure o preventruns withoutpreventingbanksfromcreating iquid-ity, and, consequently,bankpolicy issues shouldbe considered n thecontext of depositinsurance.Withdepositinsurance nplace,banksnolongerbear the downside risk of their positions since the deposit in-surer bears that risk. Consequently,there are natural ncentives forbanks to take on too much risk, andbankpolicy shouldbe designedtocounteractthose incentives.ReferencesBernanke, B. S. 1983. Nonmonetary effects of the financial crisis in the propagation ofthe Great Depression. American Economic Review 73 (June): 257-76.


15/15

68 Journal of BusinessBlack, F.; Miller, M.; and Posner, R. 1978. An approach to the regulation of bankholding companies. Journal of Business 51 (July): 379-412.Boyd, J. H., and Prescott, E. C. 1985. Financial intermediary coalitions. Working paper.Minneapolis: Federal Reserve Bank of Minneapolis, February.Bryant, J. 1980. A model of reserves, bank runs, and deposit insurance. Journal ofBanking and Finance 4 (September): 335-44.Diamond, D. W. 1984. Financial intermediation and delegated monitoring. Review ofEconomic Studies 51 (July): 393-414.Diamond, D. W., and Dybvig, P. H. 1983. Bank runs, deposit insurance, and liquidity.Journal of Political Economy 91 (June): 401-19.Dothan, U., and Williams, J. 1980. Banks, bankruptcy and public regulation. Journal ofBanking and Finance 4 (March): 65-87.Fama, E. F. 1980. Banking in the theory of finance. Journal of Monetary Economics 6(January): 39-57.Fisher, I. 1911. The Purchasing Power of Money: Its Determination and Relation toCredit, Interest and Crises. New York: Macmillan.Friedman, M., and Schwartz, A. J. 1963. A Monetary History of the United States,1867-1960. Princeton, N.J.: Princeton University Press (for the National Bureau ofEconomic Research).Gurley, J. G., and Shaw, E. S. 1960. Money in a Theory of Finance. Washington, D.C.:Brookings.Haubrich, J. 1985. Optimal financial structure in exchange economies. Working paper.Philadelphia: University of Pennsylvania, Wharton School, February.Jacklin, C. J. 1983a. Demand deposits, trading restrictions, and risk sharing. Workingpaper. Stanford, Calif.: Stanford University, Graduate School of Business.Jacklin, C. J. 1983b. Information and the choice between deposit and equity contracts.Working paper. Stanford, Calif.: Stanford University, Graduate School of Business,November.Kareken, J. H. In this issue. Federal bank regulatory policy: A description and someobservations.Kareken, J., and Wallace, N. 1978. Deposit insurance and bank regulation: A partialequilibrium exposition. Journal of Business 51 (July): 412-38.Ramakrishnan, R., and Thakor, A. 1984. Information reliability and a theory of financialintermediation. Review of Economic Studies 51 (July): 415-32.Stigum, M. 1983. The Money Market. Homewood, Ill.: Irwin.Tobin, J. 1963. Commercial banks as creators of "money." In D. Carson (ed.), Bankingand Monetary Studies. Homewood, Ill.: Irwin.Tobin, J., and Brainard, W. 1963. Financial intermediaries and the effectiveness ofmonetary control. American Economic Review 53 (May): 383-400.

Deposit Insurance Chicago

Documents

Transcript of Deposit Insurance Chicago