Deposit insurance under review

Admittedly I only managed a skim read of the FDIC report dated 1 May 2023 on “Options for Deposit Insurance Reform” but I was a bit underwhelmed given the important role deposit insurance plays in the banking system. I think the conclusion that some form of increased but “targeted” coverage makes sense but I was disappointed by the discussion of the consequences for market discipline and moral hazard that might flow from such a move.

The Report considers three options for increasing deposit insurance:

  • Limited Coverage under which the current system would be maintained but the deposit insurance limit might increased above the existing USD250,000 threshold
  • Unlimited Coverage under which all deposits would be fully insured; and
  • Targeted Coverage under which coverage for “business payment accounts” would be substantially increased without significantly changing the limit for other deposits.

The report:

  • Concludes that “Targeted Coverage … is the most promising option to improve financial stability relative to its effect on bank risk-taking, bank funding, and broader markets”
  • But notes there are significant unresolved practical challenges “…including defining accounts for additional coverage and preventing depositors and banks from circumventing differences in coverage”

What I thought was interesting was that the Report seemed to struggle to make up its mind on the role of bank depositors in market discipline. On the one hand the Report states

“Monitoring bank solvency involves fixed costs, making it both impractical and inefficient for small depositors to conduct due diligence. Monitoring banks is also time consuming and requires financial, regulatory, and legal expertise that cannot be expected of small depositors”

Executive Summary, Page 1

… and yet there are repeated references to the ways in which increasing coverage will reduce depositor discipline. The discussion of the pros and cons of Targeted Coverage, for example, states

“The primary drawbacks to providing greater or unlimited coverage to specific account types are the potential loss in depositor discipline and resulting implications for bank-risk taking”

Section6: Options for Increased Deposit Coverage”, Page 58

I am not in favour of unlimited deposit insurance coverage but if you accept that certain types of depositors can’t be expected to monitor bank solvency (and liquidity) then I can’t see the point of saying that reduced depositor discipline is a consequence of changing deposit insurance for these groups or that the “burden” of monitoring is shifted to other stakeholders.

What would have been useful I think is a discussion of which stakeholders are best suited to monitor their bank and apply market discipline. Here again I found the Report disappointing. The Report states “… other creditors and shareholders may continue to play an important role in constraining bank risk-taking …” but does not explore the issue in any real detail.

I also found it confusing that ideas like placing limits on the reliance on uninsured deposits or requirements to increase the level of junior forms of funding (equity and subordinated debt), that were listed as “Potential Complementary Tools” for Limited Coverage and Unlimited Coverage, were not considered relevant in the Targeted Coverage option (See Table 1.1, page 5).

This ties into a broader point about the role of deposit preference. Most discussions about bank deposits focus on regulation, supervision and deposit insurance as the key elements that mitigate the inherent risk that deposits will run. Arguably, the only part of this that depositors understand and care about is the deposit insurance.

I would argue that deposit preference also has an important role to play for two reasons

  • Firstly, it mitigates the cost of deposit insurance by mitigating the risk that assets will be insufficient to cover insured deposits leaving the fund to make good the loss
  • Secondly, it concentrates the debate about market discipline on the junior stakeholders who I believe are best suited to the task of monitoring bank risk taking and exercising market discipline.

I did a post here which discussed the moral hazard question in more depth but the short version is that the best source of market discipline probably lies in the space between senior debt and common equity i.e. Additional Tier 1 and Tier 2 subordinated debt. Common equity clearly has some role to play but the “skin in the game” argument just does not cut it for me. The fact that shareholders benefit from risk taking tends to work against their incentive to provide risk discipline and more capital can have the perverse effect of creating pressure to look for higher returns.

Tony – From the Outside

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

14 thoughts on “Deposit insurance under review”

  1. In my simple world a deposit should easily translate to cash eg physical paper. Unfortunately, electronic cash now has a far greater rate of conversion (liquidity). You cannot insure the whole deposit base because your cost of insurance will rise in manner an option accelerates it’s delta the closer it gets in the money. Solution now needs more innovation and possibly banks need to understand they need to pay up for this eg above the insured limits the deposit rate is higher but with vesting conditions. The sophistication of markets in being able to act on information is the real problem to be solved.


    1. George, thanks for taking interest in the post. I suspect we can all agree that digital money is probably only going to get more important and bank deposits are the main way people hold digital money. Completely agree that we should not insure all deposits but deposit insurance does seem to be necessary to ensure that bank deposits can function as money. Would be interested to learn what kind of innovation you have in mind. My view is that deposits need to be “information insensitive” as argued by Garry Gorton and the information processing role (aka market discipline) should sit with the liabilities that are junior to deposits (i.e. Additional Tier 1 and Tier 2).


      1. Hello, in response, yes some insurance is needed, but also ability to repo assets is also critical.

        tToday El-Erian wrote in the AFR and one aspect that he correctly printed out was appropriate regulation and monetoring. For instance Net stable funding ratio and Liquity coverage ratios should control some of the liquidity risk levels – what wee they in SVBs case?

        On capital I am not sure here what’s proposed but to weaken the Tier2 and AT1 instruments by embedding Liquity default options will mean increased margin and decreased volume – not sure this is helpful – as I note APRAs current debate on when can you call earlier such instruments ( if they didn’t know the rules when these were issued now is not the time to redefine the market)


      2. George. Agree that collateral matters. See Frances Coppola on Signature bank failure for good discussion. Regarding AT1 and Tier 2 I am not proposing they be weakened. Simply that they do what they are designed to. Someone has to provide risk discipline but my main point is that depositors are not the group to do this.


      3. The line between liquidity and solvency can be ambiguous at times but to be clear I am not proposing to add anything to AT1 and T2 loss absorption. The fact that they are at risk and can take a loss if required means they are the ones best placed to provide market discipline


    1. Thank you for response, yes theyAr1and Tier 2 are risk capital instruments with a focus on preservation not growth ( as you point out re equity)
      However, they have limited rights in terms of feedback to management unlike shareholders who can exercise their vote and view.

      The senior debt has more swat because they represent a sizeable funding element for a bank.

      To enact more authority to At1 and T2 in times of risk crisis ( liquidity breakdown, severe credit deterioration) you need to give them trigger points where distribution to equity cannot happen – then you have what I think you are asking for. It is also a first step to solvency control.if you embed these triggers.


  2. DI seems to have been used in an innovative and effective manner in the US recently, but whether it expands and, in some way, becomes a flexible tool to manage a digital bank run remains to be seen.

    Plenty of commentary about uninsured deposits being a (principal) cause of bank runs, eg. the Frances Coppolla piece, and therefore the remedy seems to be a need to expand DI. But I wonder how much of this is particular to the US, and not necessarily universal.

    Think of the Magnificent 7 in Fragile Design (countries that have never experienced a bank crisis): most of those countries introduced deposit insurance schemes less than 20 years ago.


      1. Point I was trying to make is that it seems like DI (or lack thereof) is becoming the central focus for (a) understanding the causes of a bank run and (b) tackling the problem through temporary or permanent DI innovations. If this line of thinking were to become universal (via Basel/FSB) then it ignores that fact that in many jurisdictions, DI – historically, culturally, politically – has never played a big role in the banking system or consumer protection more genreally; good examples of such jurisdictions include most of the 7 jurisdictions in Fragile By Design that have never experienced a banking crisis (as they only introduced DI schemes quite recently).


      2. Thanks. I think you are referring to the book “Fragile by Design” so I will have to reread to comment further. One thing I did note is that I am not sure it is true that HK has not had a banking crisis. From memory they had bank runs there in the 60s or 70s but I will review the argument the book makes before commenting further.

        Thank again


      3. Are you arguing that deposit insurance is not a desirable or useful feature of a banking system. I think Calomiris is arguing that there a certain political systems that tend to result in unstable banking systems. The banking systems he identifies as being more stable share common political structures. These systems still tend to use deposit preference and deposit insurance to mitigate the instability (run risk) that is inherent in the basic banking system design. I share Calomiris view that market discipline is important feature of any stable banking system. I think I disagree that bank depositors should be a source of this discipline and argue AT1 and other junior forms of debt are better sources of discipline. One of the problems Calomiris discusses is the political arrangements that are necessary to ensure that the right groups of stakeholders (I.e. shareholders, AT1 Tier 2) take their contractual share of losses when banks fail.


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