February

AN IMMODEST PROPOSAL

When, in 1729, Dean Swift published his “modest proposal” for relieving society of the burden of supporting the children of poor people, it was with a gleam of irony.

Now from the Centre for Policy Studies comes another “modest proposal”1: to abolish deposit insurance.

There is no irony. This, we are assured, would at a stroke make depositors safer, banks more innovative and the economy less prone to recession. So what’s not to like?

The economic logic seems impeccable. 

Because deposits are currently insured by FSCS up to £75,000, the great majority of savers have no strong incentive to consider the relative safety of different deposit takers, according to the report. Enter our old friend, moral hazard.

So deposits are cheaper for banks, building societies and credit unions than they ought to be in a world without deposit insurance. In such a world deposit takers would have to hold much more capital to convince savers they were safe and the risk of financial crisis precipitated by too high levels of leverage would reduce.

In other words, risk is mis-priced.

What could be simpler then than to bring about this world? We abolish deposit insurance and the protection provided to savers by FSCS. Instead, banks are required to tell savers all about their capital ratios or run their own mutual compensation scheme. And just to ensure that banks really do have to compete to reassure savers, the state-run NS&I would be empowered to offer savers risk-free current accounts and saving facilities.

I simplify, but this is broadly the modest proposal.

So would it work in the real world rather than in the world as envisaged by economists?

Well, for a start, consumers would have to consider leverage ratios when deciding where to deposit their income and savings. These are the same consumers who, repeated surveys show, struggle with many basic financial concepts. How are they to judge such risks?

And, in considering leverage ratios, consumers would also, of course, have to assess the quality of banks’ assets. What could be simpler? We have all been reading the exchange of correspondence about bank capital recently between Sir John Vickers on the one hand and Andrew Bailey and Jon Cunliffe at the Bank of England on the other. 

Consumers would be left to resolve these differences for themselves.

I do not think consumers want this responsibility or feel remotely equipped to exercise it. 

The result would likely be a rush to deposit money with NS&I with its 100% government guarantee. This would create liquidity pressures on deposit-takers and hugely disrupt the flow of savings to industry and domestic borrowers. Either that, or people would leave their money where it is and hope for the best.

And what would then happen when the next crisis did break and banks, building societies or credit unions got into difficulty or were rumoured to be in difficulty?

We know the answer to that. We saw it in the United States in the 1930s. We saw it on a smaller scale when Robert Peston broke the Northern Rock story in 2007.  Consumers without deposit protection or with partial protection (as in the UK in 2007) would rush to withdraw their money. Liquidity pressures would intensify. Banks would fail.

That, after all, is why deposit insurance was introduced in the United States. The concept of moral hazard is great until the hazard eventuates. And then it’s not.  Deposit protection provides confidence to consumers when confidence is what is most needed to maintain stability.

The CPS does have an answer to this: namely, that savers will be reassured by the fact they are preferred creditors and likely to make a full recovery of their funds in a liquidation.

I can hear the Chancellor of the day deploying this argument now!

So deposit insurance may offend moral hazard in its pure form. But it’s a pragmatic response to the world as it is which underpins public confidence in the stability of our financial services.

And, by the way, contrary to the CPS’ pamphlet, deposit insurance is funded by the industry, not the taxpayer.


1 The Abolition of Deposit Insurance – a modest proposal for banking reform by Andreas Wesemann


Jargon Buster

Deposits

money placed in a bank or similar institution to earn interest or for safe-keeping.

Mutual

An organisation with no stockholders. Profit, losses and expenses are shared by members.