Question

Be able to discuss the link between deposit insurance systems and bank regulation. Also, be able to identify the deposit insurance authority in the US banking industry. Remember that credit unions’ deposits are insured by the NCUA (which is also the primary federal regulator of credit unions).

Answer 1

Banks that offer transaction deposits are supposedly subject to an "inherent instability problem" that makes them prone to self-realizing depositor panics. Traditionally, transaction deposits are denominated as a fixed number of currency units, while the assets corresponding to these deposits are mostly finite-term securities or commercial loans. If depositors all want their money at once, the banks simply do not have it. To the extent that their assets are marketable, the banks can sell them off to meet withdrawals with only minimal losses. But if there is a run on the banking system as a whole, the banks' scramble for funds could conceivably drive interest rates up and asset prices down to the point at which the banks are actually insolvent simply because of depositor fears that they might fail. To the extent that bank assets consist of poorly marketable commercial loans, they are even more exposed to the risk of runs. This inherent instability problem is the most commonly cited argument for government deposit insurance and the care-ful government regulation it entails (or ought to entail).
However, the money market mutual fund (MMMF) is a recent market innovation that completely solves this inherent instability problem of the payments system. As Kareken points out in his paper, MMMFs, like all mutual funds, are run proof since their obligations to their investors are simply pro rata shares in the current market value of the fund's portfolio. To the extent that depositors/investors line up at the front door to take their money out, the rate of return to depositing new funds will increase, and new depositors/investors will line up at the back door to put their money in. As long as the fund sticks to very short term instruments (20 days is a common average maturity for existing MMMFs), fluctuations in the market value of the portfolio will hardly be perceptible, and balances will be predictable enough to make check writing practical.

Banks holding 100% reserves in the traditional sense would be at least potentially available in the absence of government deposit insurance for those who want complete certainty of present value. How-ever, if these reserves paid no interest, as would be the case under a metallic standard or under the Federal Reserve's current policy, banks could offer no interest on their transactions deposits and in fact might charge a small fee ("negative interest") for their trouble. My guess is that most depositors would prefer to receive healthy interest on an MMMF account and live with the minor inconvenience of slightly un-certain present value rather than to hold such accounts.

Diamond and Dybvig (1983) have shown, in an article approvingly cited by Kareken, that, under sufficiently simplifying assumptions, fixed present value deposits with mandatory government deposit insurance may be Pareto superior to any voluntary contractual arrangement.

The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for at least $250,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails.