Question

A history of deposit insurance on the web site of the FDIC notes: "Some have argued at different points in time that there have been too few bank failures because of deposit insurance, that it undermines market discipline, and that it amounts to a federal subsidy for banking companies."

a. What does it mean to describe insurance as undermining "market discipline"? From this perspective, why might deposit insurance lead to too few bank failures?

b. In what sense might deposit insurance be considered a federal subsidy for banks?

c. If deposit insurance has these drawbacks, why do economists and members of congress overwhelmingly support it?

Answer 1

Introduction

To understand the concepts of deposit insurance, it is important to understand how it works in regards to the general banking practices of a country.

Usually, banks are allowed to give away as loans a major portion of their collections as loans, and through which they earn in the form of interests. Banks are like any other business and their primary earning comes from the difference between their obligations and their income which takes place when people take loans from them.

Though, there are only a few instances of banks as financial institutions failing, yet governments across many countries have brought in the concepts of deposit insurance which protects the interest of the deposit holders, the banks and the economy as a whole.

The concept was created in the United States, primarily to safeguard banks in case of defaults in smaller towns and villages. This however, translated into long term reliance by banks which largely invested in deposit insurance to safeguard their own interests in which they may insure full or part of their loans which they have granted to the general public

Case Specifics:-

What does it mean to describe insurance as undermining "market discipline"? From this perspective, why might deposit insurance lead to too few bank failures?

Deposit insurances, protect the interests of banks which grant loans to the consumers. As a policy, however it can be debated to be causing problems in terms of market discipline which refers to the act of giving loans as per set guided rules rather than just aiming for higher profit margins.

Banks, usually give out loans based on perceived default risk. In case they have the protection of insurances readily available, they would be more lenient towards giving away loans. As a result of which market discipline gets spoiled to a certain extent respectively.

This in the long run translates into very few bank failures, since the loans granted by banks are mostly covered in insurance. In case of defaults, the capital amount can be recovered as per the terms of the insurance policy taken, and in case the loan holder pays money in time, the bank generates significant profits. Thus they practice can lead to situations in which banks forget market discipline and grant loans in such a manner that market discipline gets hampered because they know their interests are safeguarded by the insurance policy respectively.

B) In what sense might deposit insurance be considered a federal subsidy for banks?

Since, losses in terms of the defaults by customers of the banks, are safeguarded by deposit insurances which they buy, usually from the central bank which is a government undertaking, it can be said that it acts like a federal subsidy for banks, ensuring that they do not make significant losses in the long run and are secured to a certain extent.

Therefore, people correctly argue, that deposit insurances can be considered to be a federal subsidy for banks since the government of the country is backing bad debts for banks

(C) If deposit insurance has these drawbacks, why do economists and members of congress overwhelmingly support it?

Even when deposit insurances have the drawback that they lead to market problems, and that banks become more careless while giving loans, economists, and members of the congress readily support it because they fear that defaults can turn out to be a catastrophe for the market place.

Also, insurance premiums are fully paid by banks, thus ensuring minimum support levels when the central bank is required to pay in case people default and the insurance policy is matured by the banks.

Thus, to allow greater stability in the economy and to ensure that damages to banks to not lead to long term recessions, deposit insurances get supported by the government and economists in general.