The political economy of deposit insurance and why did deposit insurance pick up?

Nice piece by Charles Calomiris and Matthew Jaremski.

Many of us might no know that India was the second country after US to introduce deposit insurance. US introduced it in 1934 and India in 1961. In both countries, central banks primarily came up to look at the banking crises. Paradoxically, bank failures only grew post central banks coming up int eh two countries. It actually boiled down to introducing this deposit insurance scheme which stabilised the system and prevented bank runs.

One can always argue over costs and benefits of deposit insurance. But the kind of drama we have over central banks role in financial stability, much credit goes to these deposit insurance schemes as well. Though, this insurance bit has obviously interfered with market mechanisms. Earlier depositors had atleast some incentives to try and figure good banks from bad ones. There was some process for that weeding to happen. Now there is no such incentive as you know govt will give back your deposits via this deposit insurance scheme. It is also true that banks do not promise to pay back all your deposits in case of a crash. The insured amount is only RS 1 lakh and anything more you will lose that money. But as this  has barely happened, so depositors given their savings fully confident that 100% money will come back. All banks have become too big to fail no matter how small they are in the scheme of  things.

Coming to the topic. The authors say it is really surprising that the world took so long to introduce this facility after US introduced it in 1934. What triggered the rise? Politics of course:

Liability insurance is a fundamental part of banking regulation of today, but despite being accepted as best practice now, it did not expand out of the US until the second half of the 20th century. This column discusses economic and political explanations for the spread of liability insurance availability, and finds that a political explanation reflects the empirical evidence well. Liability insurance was preferable to other policies despite being inefficient, due to its use as political leverage. 

 There are two theories to deposit insurance – economic and political:
Economic theories show how liability insurance may improve the efficient management of the banking system by reducing systemic liquidity risk. Government-provided deposit insurance eliminates the incentive for depositors to run a bank in anticipation of other depositors doing so. Despite that potential advantage, economic theories also recognise that there are costs of enacting liability insurance. Models of principal-agent conflicts such as Calomiris and Kahn (1991) show that demandable debt contracts allow depositors to subject banks to ‘market discipline’, which rewards good behaviour and punishes bad. Because insurance reduces the incentive for market discipline, it may increase fundamental insolvency risk as a consequence of greater conscious risk taking by bankers (i.e. moral hazard), or through an increase in the proportion of bankers who are incompetent managers (i.e. adverse selection). Therefore, whether, on balance, bank liability insurance reduces or increases risk in the banking system is an empirical question. Economic theories of liability insurance only make sense on economic grounds if the gains from liquidity risk reduction tend to exceed the moral hazard or adverse selection costs from reduced market discipline.
Political theory provides a separate theoretical basis for bank liability insurance. Political bargaining models identify circumstances under which the interests of particular groups within society (i.e. the beneficiaries of passing liability insurance) may succeed in securing its passage, even though liability insurance may be inefficient (Stigler 1971, Peltzman 1976, Becker 1983). Political models seek to explain why liability insurance may be chosen to favour certain groups in society even when it imposes large costs on society in the form of higher systemic risk for banks. In this context, liability insurance needs to be understood as part of an equilibrium political bargain achieved by a winning political coalition. Consequently, its function may vary across countries as a result of the differing political functions that it plays in different regimes and contexts.
To sort between the two types of theories, we review empirical evidence about, first, which factors are shown to be instrumental in creating bank liability insurance; and second, evidence about the consequences of passing insurance (that is, whether insurance has improved the stability of banking systems). We find that political theories are much more consistent with both sets of evidence.
How did it start in US? It actually started before 1934:

First, the historical push for liability insurance in the US came from a coalition of small rural bankers and landowning farmers. The insurance of bank liabilities began as a US experiment in a handful of states during the early-to-mid 19th century. Liability insurance was confined to the North (New York, Indiana, Ohio, Vermont, Michigan and Iowa) where banks were limited by ‘unit banking’ laws to operate without branches. Unit banks were less diversified in their lending, and a system of unit banks was less able to coordinate banks’ actions in response to problems. Both aspects made unit banking systems less stable, and liability insurance was conceived as a means of reducing systemic risk while preserving unit banking limits. Unit banking limits had political appeal to landowning farmers who supported them as a means of tying banks to the local economy, and thereby making banks more willing to lend in the wake of adverse shocks to crop prices and land values. In contrast, banks in the antebellum South typically operated branch networks that were able to coordinate their responses to crises (such as the Panic of 1857), instead of adopting bank liability insurance schemes.

The early state liability insurance systems disappeared by the 1860s, either as a consequence of unsustainable losses and financial collapse (in New York, Vermont and Michigan) or as the result of Civil War tax policies that drove them out of existence (in Indiana, Ohio and Iowa).

A second wave of liability insurance systems arose in the early 20th century, in eight US states as the result of agrarian political support for unit banking. All of the eight systems collapsed within a few years of their founding. Despite those failures, US federal deposit insurance was enacted in 1933, again at the behest of unit banking champions such as Rep. Henry Steagall of Alabama, and over the objections of the Federal Reserve, the Treasury, the American Bankers Association, and President Franklin Roosevelt.

Why it picked up worldwide? Surprise, surprise. The doyen of free markets IMF etc supported the move:

Worldwide, bank liability insurance remained a unique (and controversial) policy choice of the US until the late 1950s, but it spread rapidly throughout the world in recent decades, as shown in Figure 1. Today it is a nearly ubiquitous feature of banking regulation endorsed by influential cross-border institutions such as the IMF, the World Bank, and the EU.

Figure 1 Adoption of deposit insurance

Source: Demirgüç-Kunt et al. (2014).

Like the adoption of liability insurance in the US, the recent global wave of legislation creating and expanding insurance can also be traced to political influences. For example, deposit insurance is more common in countries with a more contestable political system (proxied, among other ways, by polity score) and with larger and more under-capitalised banks, as shown by Demirgüç-Kunt et al. (2008). Modern multilateral institutions such as the IMF, the World Bank, and the EU have also played a large role in using their political clout to encourage adoption of deposit insurance or expansion of its generosity.

The expansion of liability insurance has been generally associated with reductions in banking system stability. For the early 20th century US deposit insurance systems, we show in another recent paper that insured banks were able to attract deposits away from uninsured banks that were subject to market discipline (Calomiris and Jaremski 2016b). Insured banks were able to do so despite their increasing default risk profile. Similarly, empirical studies have uniformly found that modern deposit insurance encourages greater risk-taking, reduces market discipline, and negatively affects the growth of the financial system. For example, Calomiris and Chen (2016) find that exogenous external political pressures that lead a country to adopt or expand deposit insurance are associated with higher banking system leverage and higher asset risk (higher loans relative to assets). Therefore, although insurance is justified economically as a banks typically dominates the liquidity risk reduction, resulting in greater overall banking instability.

Exciting area of research.  What was the politics behind start of deposit insurance in India? It was a highly charged up political environment in 1960s. One doubts whether economic theory alone explains start of deposit insurance in India..


4 Responses to “The political economy of deposit insurance and why did deposit insurance pick up?”

  1. Roy Says:

    Hi Amol! you may want to check out fragile by design by Fukuyama…very interesting book on the same topic

  2. Amol Agrawal Says:

    Hi Roy! Thanks for the comment. Actually the book you mentioned is by Calomiris himself along with Stephen Haber. Calomiris has been writing about these things for a while..

  3. Roy Says:

    Hi Amol! Sorry, my mistake I got confused between origins of political order and fragile by design! Perils of reading 2 books at the same time on 2 devices!

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