Deposit Insurance

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

Marc Rubinstein on deposit insurance

Marc Rubinstein offers a nice summary of the history of deposit insurance in the USA. The post is short and worth reading but the short version is captured in his conclusion…

Deposit insurance was never meant to preserve wealth … It was meant to preserve the functioning of the banking system. What the correct number is to accomplish that is a guess, but it’s going up.

History of the Fed

I love a good podcast recommendation. In that spirit I attached a link to an interview with Lev Menand on the Hidden Forces podcast. The broader focus of the interview is the rise of shadow banking and the risks of a financial crisis but there is a section (starting around 21:20 minute mark) where Lev and Demetri discuss the origin of central banking and the development of the Fed in the context of the overall development of the US banking system.

The discussion ranges over

The creation of the Bank of England (23:20)
The point at which central banks transitioned from being simple payment banks to credit creation (24:10) institutions with monetary policy responsibilities
The problems the US founders faced creating a nation state without its own money (25:30)
Outsourcing money creation in the US to private banks via public/private partnership model (26:50)
The problems of a fragmented national market for money with high transmission costs (27:40)
The origin of the Federal Reserve in 1913 (31.50) and the evolution of banking in the US that preceded its creation which helps explain the organisational form it took

… and a lot more including a discussion of the rise of shadow banking in the Euromarket.

The topic is irredeemingly nerdy I know and it will not tell you much new if you are already engaged with the history of banking but it does offer a pretty good overview if you are interested but not up for reading multiple books.

Tony – From the Outside

I recently flagged a post by Patrick McKenzie on the mechanics of the humble bank deposit. Patrick has followed that with another equally interesting discussion of deposit insurance. The post is written as a high level primer and so it does not offer any insights to anyone already familiar with the topic.

The main thing that grabbed my attention was Patrick’s emphasis on the “information insensitive” nature of bank deposits. This to my mind is a fundamental concept in analysing bank deposits but gets way less attention that I think it deserves. It is particularly important when you are looking at the question of the extent to which deposit insurance promotes moral hazard.

So it was good to see someone else promoting the importance of this concept. On the other hand, his discussion of the information insensitivity of deposits does not give as much attention to the role of “deposit preference” as I think it deserves. It is always possible of course that I have this wrong but, for me at least, the preferred claim that many jurisdictions afford bank deposits is a key part of understanding why bank deposits can be information insensitive” without necessarily creating moral hazard.

If you are interested to dig deeper ….

Matt Levine did a good post on the overall question of how finance uses tranching to turn a pool of risky assets into a mix of safe and risky claims on those assets where he described this as “A main move in finance” (see here for my summary of the column if you don’t have access to his column)
There is also a page on my website where I discuss the arguments for protecting depositors (the “why”), another where I attempt to dig a bit deeper into the technical aspects of bank deposit protection (the “how”), and this post offering an Australian perspective on the process of how bank deposits (a loan to highly leveraged company) get turned into mostly risk free assets in the hands of bank depositors.

Tony – From the Outside

The alchemy of deposits

Patrick McKenzie dropped an interesting post on the seemingly humble but actually quite awesome deposit. You can find my (Australian focussed) perspective on the mechanics of bank deposits here but who could resist learning more about “…the terrible majesty of the humble bank deposit”.

The perspective Patrick offers is not necessarily new for anyone who understands banking but a lot of this is probably not well understood by the broader public actually using bank deposits. His post is short and worth reading if only for the “pink slime” analogy.

His first point is that “deposits are money”

The actual core feature of deposits is that you can transfer them to other people to effect payments. Big deal, you might think. You can also transfer cows, sea shells, Bitcoin, an IOU from a friend, or bonds issued by Google to effect payments. But deposits are treated as money by just about everyone who matters in the economy, including (pointedly) the state. Economists can wax lyrical about what “treated as money” means, but the non-specialist gloss is probably just as useful: anything is money if substantially everyone looking at the money both agrees that it is money and agrees at the exchange rate for it. This is sometimes referred to as the “no questions asked” property; money is the Schelling point for value transfers that all parties to a transaction are already at.
This is so fundamental a feature of deposits that, in developed nations, we don’t remember that it isn’t automatic

His second point is that bank deposits are “heavily engineered structured products pretending to be simple”.

From the consumer’s perspective, deposits are “my money,” functionally riskless. This rounds to correct. From the bank’s perspective, deposits are part of the capital stack of the bank, allowing it to engage in a variety of risky businesses. This rounds to correct. The reconciliation between this polymorphism is a feat of financial and social engineering. A bank packages up its various risky businesses—chiefly making loans, but many banks have other functions in addition to the risks associated with any operating business—puts them in a blender, reduces them to a homogenous mix, and then pours that risk mix over a defined waterfall.
The simplest model for that waterfall is, in order of increasing risk: deposits, bonds, preferred equity, and common equit

The “pink slime” analogy referenced above is a colourful way of saying that deposits benefit from having a claim on a diversified pool of assets, the “homogeneous mix” in the extract above. Equally important however is the fact that deposits have a super senior claim on that diversified pool as outlined in the waterfall analogy.

Patrick has packed quite a few nice turns of phrase into his post but one of my favourites addresses the pervasive misuse of the term “deposit”

The fintech industry has not covered itself in glory here. Sometimes firms misclaim a product to be a deposit where it is not. Sometimes they actually institutionally misunderstand the nature of the product they have created. One would hope that that never happens, but … smart people are doomed to continue discovering that just because a deposit is a complex structured product involving a bank which has a stable dollar value, not every complex structured product involving a bank which appears to have a stable dollar value is actually a deposit

To repeat “…just because a deposit is a complex structured product involving a bank which has a stable dollar value, not every complex structured product involving a bank which appears to have a stable dollar value is actually a deposit”

Patrick uses the recent example of Voyager as a case in point. I don’t think it is being pedantic to argue that a “crypto bank” is an oxymoron but I don’t hold out much hope that the term will go away any time soon. A “bank” is arguably a highly regulated institution by definition and the crypto versions to date are either not regulated or subject to a less onerous form of regulation.

This is Patrick’s take on Voyager

Voyager, a publicly traded company, marketed a deposit-adjacent product to users, paying a generous interest rate. Then a cascading series of events in crypto, outside the scope of this essay, blew up a series of firms, including one which had taken out a loan of hundreds of millions of dollars from Voyager. Suddenly, the information-insensitivity of Voyagers not-deposits was pierced, the pink slime appears both undermixed and undercooked, and customers now need to follow a bankruptcy proceeding closely. … When something which was believed to be a deposit is discovered to not actually be a deposit, infrastructure around it breaks catastrophically. Matt Levine has an excellent extended discussion about how Voyager discovered that attaching the ACH payment rail to their deposit-adjacent product became a huge risk once they went under.)

As regular readers will know, I am a big fan of Matt Levine so I endorse Patrick’s recommendation to read Matt’s accounts of what is going on in the crypto world. There is one aspect of Patrick’s post however that I struggled with and that is his account of bank deposits as a cheap source of funding

Why fund the risks of a bank with deposits, as opposed to funding them entirely with bonds and equity (and of course, revenue), like almost all businesses do? From the bank’s perspective, this is simple: deposits are very inexpensive funding sources, and the capability to raise them is the one of the main structural advantages banks have vis-a-vis all other firms in the economy.

He is correct of course in the sense that the nominal interest rate on bank deposits is quite low, commensurate with their low risk. Two observations however,

Firstly, the true cost of a bank deposit has to take account of the cost of running all the infrastructure that facilities creating a diversified pool of assets and operating the payment rails that allow deposits to effect payments.

The second is that the super senior preferred claim that bank deposits have on the waterfall makes the other parts of the bank liability stack more risky. I know that the “bail-out” or “Too Big To Fail” have traditionally created a subsidy. However, banks are now required to hold both a lot more capital and to issue “bail-in” instruments that should in principle mean that this subsidy is much reduced if not eliminated. If the other parts of the bank liability stack are not pricing in these changes then the really interesting question is why not.

So there is a lot more to this than what Patrick has written (and he has promised further instalments) but I can still recommend his post as a useful (and entertaining) read for anyone seeking a better understanding of this particular corner of the banking universe.

Tony – From the Outside

Adam Tooze wants everyone to read “The Currency of Politics” by Stefan Eich

I have only just started reading the book myself but the outline that Adam Tooze offers suggests to me that it has a lot to say on an important topic.

At this stage I will have to quote the author for a sense of what this book is about ..

The Currency of Politics is about the layers of past monetary crises that continue to shape our idea of what money is and what it can do politically. Grappling with past crises helped previous theorists to escape the blindspots of their own time. We must do the same today.

This seems like a pretty worthwhile endeavour to me so I thought it was worth sharing for anyone else engaged in trying to make sense of the role that money (and banking) does and should play in our society.

Tony – From the Outside

Separating deposit-taking from investment banking: new evidence on an old question

The BOE has released a paper exploring the question of how ring fencing deposit taking from investment banking impacts the banking market. I have included the abstract of the paper below and you can find a summary of the paper here on the “Bank Underground” blog. I don’t see this as the final word on these questions but it does offer a perspective worth noting.

Abstract
The idea of separating retail and investment banking remains controversial. Exploiting the introduction of UK ring-fencing requirements in 2019, we document novel implications of such separation for credit and liquidity supply, competition, and risk-taking via a funding structure channel.
By preventing conglomerates from using retail deposits to fund investment banking activities, this separation leads conglomerates to rebalance their activities towards domestic mortgage lending and away from supplying credit lines and underwriting services to large corporates.
By redirecting the benefits of deposit funding towards the retail market, this rebalancing reduces the cost of credit for households, without eroding lending standards. However the rebalancing also increases mortgage market concentration and risk-taking by smaller banks via indirect competition effects.

Tony – From the Outside

Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective

The ability to raise funding via “deposits” is one of the things that makes banks different from other types of companies. As a rule bank deposits benefit from a variety of protections that transform what is effectively an unsecured loan to a highly leveraged company into an (arguably) risk free asset.

This rule is not universal however. The NZ banking system, for example, had (at the time this post was written) a distinctly different approach to bank deposits that not only eschews the protections Australian depositors take for granted but also has the power, via its Open Banking Resolution regime, to write down the value of bank deposits if required to ensure the solvency and viability of a bank. But some form of protection is common.

I previously had a go at the question of “why” bank deposits should be protected here.

This post focuses on the mechanics of “how” AUD denominated deposits held with APRA authorised deposit-taking institutions incorporated in Australia (“Australian ADIs” or “Australian banks”) are protected. In particular, I attempt to rank the relative importance of the various protections built into the Australian system. You may not necessarily agree with my ranking and that is OK – I would welcome feedback on what I may be missing.

Multiple layers of protection

Australian bank deposits benefit from multiple layers of protection:

The risk taking activities of the banks are subject to a high level of supervision and regulation (that is true to varying degrees for most banking systems but Australian standards do seem to be at the more conservative end of the spectrum where Basel Committee standards offer a choice),
The target level of Common Equity Tier 1 (CET1) capital required to support that risk must meet the standard of being “Unquestionably Strong”,
This core capital requirement is supported by a series of supplementary layers of loss absorbing capital that can be converted into equity if the viability of the bank as a going concern comes into doubt,
The deposits themselves have a priority super senior claim on the Australian assets of the bank should it fail, and
The timely repayments of AUD deposits up to $250,000 per person per bank is guaranteed by the Australian Government.

Deposit preference rules …

The government guarantee might seem like the obvious candidate for the layer of protection that counts for the most, but I am not so sure. All the layers of protection obviously contribute but my vote goes to deposit preference. The capacity to bail-in the supplementary capital gets an honourable mention. These seem to me to be the two elements that ultimately underwrite the safety of the majority of bank deposits (by value) in Australia.

The other elements are also important but …

Intensive supervision clearly helps ensure that banks are well managed and not taking excessive risks but experience demonstrates that it does not guarantee that banks will not make mistakes. The Unquestionably Strong benchmark for CET1 capital developed in response to one of the recommendations of the 2014 Financial System Inquiry also helps but again does not guarantee that banks will not find some new (or not so new) way to blow themselves up.

At face value, the government guarantee seems like it would be all you need to know about the safety of bank deposits (provided you are not dealing with the high quality problem of having more than AUD250,000 in your bank account). When you look at the detail though, the role the government guarantee plays in underwriting the safety of bank deposits seems pretty limited, especially if you hold you deposit account with one of the larger ADIs. The first point to note is that the guarantee will only come into play if a series of conditions are met including that APRA consider that the ADI is insolvent and that the Treasurer determines that it is necessary.

In practice, recourse to the guarantee might be required for a small ADI heavily reliant on deposit funding but I suspect that this chain of events is extremely unlikely to play out for one of the bigger banks. That is partly because the risk of insolvency has been substantially reduced by higher CET1 requirements (for the larger ADI in particular) but also because the government now has a range of tools that allow it to bail-in rather than bail-out certain bank creditors that rank below depositors in the loss hierarchy. There are no great choices when dealing with troubled banks but my guess is that the authorities will choose bail-in over liquidation any time they are dealing with one of the larger ADIs.

If deposit preference rules, why doesn’t everyone do it?

Banking systems often seem to evolve in response to specific issues of the day rather than being the result of some grand design. So far as I can tell, it seems that the countries that have chosen not to pursue deposit preference have done so on the grounds that making deposits too safe dilutes market discipline and in the worst case invites moral hazard. That is very clearly the case in the choices that New Zealand has made (see above) and the resources they devote to the disclosure of information regarding the relative risk and strength of their banks.

I understand the theory being applied here and completely agree that market discipline should be encouraged while moral hazard is something to be avoided at all costs. That said, it does not seem reasonable to me to expect that the average bank deposit account holder is capable of making the risk assessments the theory requires, nor the capacity to bear the consequences of getting it wrong.

Bank deposits also function as one of the primary forms of money in most developed economies but need to be insulated from risk if they are to perform this role. Deposit preference not only helps to insulate this component of our money supply from risk, it also tends to transfer the risk to investors (debt and equity) who do have the skills and the capacity to assess and absorb it, thereby encouraging market discipline.

The point I am making here is very similar to the arguments that Grant Turner listed in favour of deposit protection in a paper published in the RBA Bulletin.

There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.
Depositor Protection in Australia, Grant Turner, RBA Bulletin December Quarter 2011 (p45)

For a more technical discussion of these arguments I can recommend a paper by Gary Gorton and George Pennacchi titled “Financial Intermediation and Liquidity Creation” that I wrote about in this post.

Deposit preference potentially strengthens market discipline

I argued above that deposit preference potentially strengthens market discipline by transferring risk to debt and equity investors who have the skills to assess the risk, are paid a risk premium for doing so and, equally as importantly, the capacity to absorb the downside should a bank get into trouble. I recognise of course that this argument is strongest for the larger ADIs which have substantial layers of senior and subordinated debt that help ensure that deposits are materially insulated from bank risk. The capacity to bail-in a layer of this funding, independent of the conventional liquidation process, further adds to the protection of depositors while concentrating the role of market discipline where it belongs.

This market discipline role is one of the chief reasons I think “bail-in” adds to the resilience of the system in ways that higher equity requirements do not. The “skin in the game” these investors have is every bit as real as that the equity investors do, but they have less incentive to tolerate excessive or undisciplined risk taking.

The market discipline argument is less strong for the smaller ADIs which rely on deposits for a greater share of their funding but these entities account for a smaller share of bank deposits and can be liquidated if required with less disruption with the assistance of the government guarantee. The government guarantee seems to be more valuable for these ADIs than it is for the larger ADIs which are subject to a greater level of self-insurance.

Deposit preference plus ex ante funding of the deposit guarantee favours the smaller ADI

Interestingly, the ex ante nature of the funding of the government guarantee means that the ADIs for which it is least valuable (the survivors in general and the larger ADI’s in particular) are also the ones that will be called upon to pay the levy to make good any shortfalls not covered by deposit preference. That is at odds with the principle of risk based pricing that features in the literature about deposit guarantees but arguably a reasonable subsidy that assists the smaller ADIs to compete with larger ADI that have the benefit of risk diversification and economies of scale.

Summing up

If you want to dig deeper into this question, I have summarised the technical detail of the Australian deposit protection arrangements here. It is a little dated now but I can also recommend the article by Grant Turner published in the RBA Bulletin (December 2011) titled “Depositor Protection in Australia” which I quoted from above.

As always, it is entirely possible that I am missing something – if so let me know.

Tony – From The Outside

Digital money – FT Alphaville

FT Alphaville is one of my go to sources for information and insight. The Alphaville post flagged below discusses the discussion paper recently released by the Bank of England on the pros and cons of a Central Bank Digital Currency. It is obviously a technical issue but worth at least scanning if you have any interest in banking and ways in which the concept of “money” may be evolving.

Read on ftalphaville.ft.com/2020/03/12/1584053069000/Digital-stimulus/

Deposit insurance and moral hazard

Depositors tend to be a protected species

It is generally agreed that bank deposits have a privileged position in the financial system. There are exceptions to the rule such as NZ which, not only eschews deposit insurance, but also the practice of granting deposits a preferred (or super senior) claim on the assets of the bank. NZ also has a unique approach to bank resolution which clearly includes imposing losses on bank deposits as part of the recapitalisation process. Deposit insurance is under review in NZ but it is less clear if that review contemplates revisiting the question of deposit preference.

The more common practice is for deposits to rank at, or near, the top of the queue in their claim on the assets of the issuing bank. This preferred claim is often supported by some form of limited deposit insurance (increasingly so post the Global Financial Crisis of 2008). An assessment of the full benefit has to consider the cost of providing the payment infrastructure that bank depositors require but the issuing bank benefits from the capacity to raise funds at relatively low interest rates. The capacity to raise funding in the form of deposits also tends to mean that the issuing banks will be heavily regulated which adds another layer of cost.

The question is whether depositors should be protected

I am aware of two main arguments for protecting depositors:

One is to protect the savings of financially unsophisticated individuals and small businesses.
The other major benefit relates to the short-term, on-demand, nature of deposits that makes them convenient for settling transactions but can also lead to a ‘bank run’.

The fact is that retail depositors are simply not well equipped to evaluate the solvency and liquidity of a bank. Given that even the professionals can fail to detect problems in banks, it is not clear why people who will tend to lie at the unsophisticated end of the spectrum should be expected to do any better. However, the unsophisticated investor argument by itself is probably not sufficient. We allow these individuals to invest in the shares of banks and other risky investments so what is special about deposits.

The more fundamental issue is that, by virtue of the way in which they function as a form of money, bank deposits should not be analysed as “investments”. To function as money the par value of bank deposits must be unquestioned and effectively a matter of faith or trust. Deposit insurance and deposit preference are the tools we use to underwrite the safety and liquidity of bank deposits and this is essential if bank deposits are to function as money. We know the economy needs money to facilitate economic activity so if bank deposits don’t perform this function then you need something else that does. Whatever the alternative form of money decided on, you are still left with the core issue of how to make it safe and liquid.

Quote
“The capacity of a financial instrument like a bank deposit to be accepted and used as money depends on the ability of uninformed agents to trade it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty”
Gary Gorton and George Pennacchi “Financial Intermediaries and Liquidity Creation”

I recognise that fintech solutions are increasingly offering alternative payment mechanisms that offer some of the functions of money but to date these still ultimately rely on a bank with a settlement account at the central bank to function. This post on Alphaville is worth reading if you are interested in this area of financial innovation. The short version is that fintechs have not been able to create new money in the way banks do but this might be changing.

But what about moral hazard?

There is an argument that depositors should not be a protected class because insulation from risk creates moral hazard.

While government deposit insurance has proven very successful in protecting banks from runs, it does so at a cost because it leads to moral hazard (Santos, 2000, p. 8). By offering a guarantee that depositors are not subject to loss, the provider of deposit insurance bears the risk that they would otherwise have borne.
According to Dr Sam Wylie (2009, p. 7) from the Melbourne Business School:
“The Government eliminates the adverse selection problem of depositors by insuring them against default by the bank. In doing so the Government creates a moral hazard problem for itself. The deposit insurance gives banks an incentive to make higher risk loans that have commensurately higher interest payments. Why?, because they are then betting with taxpayer’s money. If the riskier loans are repaid the owners of the bank get the benefit. If not, and the bank’s assets cannot cover liabilities, then the Government must make up the shortfall”
Reconciling Prudential Regulation with Competition, Pegasus Economics, May 2019 (p17)

A financial system that creates moral hazard is clearly undesirable but, for the reasons set out above, it is less clear to me that bank depositors are the right set of stakeholders to take on the responsibility of imposing market discipline on banks. There is a very real problem here but requiring depositors to take on this task is not the answer.

The paper by Gorton and Pennacchi that I referred to above notes that there is a variety of ways to make bank deposits liquid (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the assets of the bank that any volatility in their value is of no concern. This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does. Combining deposit insurance with a preferred claim on a bank’s assets also means that the government can underwrite deposit insurance with very little risk of loss.

It is also important I think to recognise that deposit preference moves the risk to other parts of the balance sheet that are arguably better suited to the task of exercising market discipline. The quote above from Pegasus Economics focussed on deposit insurance and I think has a fair point if the effect is simply to move risk from depositors to the government. That is part of the reason why I think that deposit preference, combined with how the deposit insurance is funded, are also key elements of the answer.

Designing a banking system that addresses the role of bank deposits as the primary form of money without the moral hazard problem

I have argued that the discussion of moral hazard is much more productive when the risk of failure is directed at stakeholders who have the expertise to monitor bank balance sheets, the capacity to absorb the risk and who are compensated for undertaking this responsibility. If depositors are not well suited to the market discipline task then who should bear the responsibility?

Senior unsecured debt
Non preferred senior debt (Tier 3 capital?)
Subordinated debt (i.e. Tier 2 capital)
Additional Tier 1 (AT1)
Common Equity Tier 1 (CET1)

There is a tension between liquidity and risk. Any security that is risky may be liquid during normal market conditions but this “liquidity” cannot be relied on under adverse conditions. Senior debt can in principle be a risky asset but most big banks will also aim to be able to issue senior debt on the best terms they can achieve to maximise liquidity. In practice, this means that big banks will probably aim for a Long Term Senior Debt Rating that is safely above the “investment grade” threshold. Investment grade ratings offer not just the capacity top issue at relatively low credit spreads but also, and possibly more importantly, access to a deeper and more reliable pool of funding.

Cheaper funding is nice to have but reliable access to funding is a life and death issue for banks when they have to continually roll over maturing debt to keep the wheels of their business turning. This is also the space where banks can access the pools of really long term funding that are essential to meet the liquidity and long term funding requirements that have been introduced under Basel III.

The best source of market discipline probably lies in the space between senior debt and common equity

I imagine that not every one will agree with me on this but I do not see common equity as a great source of market discipline on banks. Common equity is clearly a risky asset but the fact that shareholders benefit from taking risk is also a reason why they are inclined to give greater weight to the upside than to the downside when considering risk reward choices. As a consequence, I am not a fan of the “big equity” approach to bank capital requirements.

In my view, the best place to look for market discipline and the control of moral hazard in banking lies in securities that fill the gap between senior unsecured debt and common equity; i.e. non-preferred senior debt, subordinated debt and Additional Tier 1. I also see value in having multiple layers of loss absorption as opposed to one big homogeneous layer of loss absorption. This is partly because it can be more cost effective to find different groups of investors with different risk appetites. Possibly more important is that multiple layers offer both the banks and supervisors more flexibility in the size and impact of the way these instruments are used to recapitalise the bank.

Summing up …

I have held off putting this post up because I wanted the time to think through the issues and ensure (to the best of my ability) that I was not missing something. There remains the very real possibility that I am still missing something. That said, I do believe that understanding the role that bank deposits play as the primary form of money is fundamental to any complete discussion of the questions of deposit insurance, deposit preference and moral hazard in banking.

Tony