The Unintended Consequences of Deposit Insurance

Alan Blinder and Glenn Hubbard make a good point today:

Memo to Washington: Take a deep breath and ask, "What is the problem that unlimited deposit insurance is meant to solve?"

It is not people lining up to take their money out of banks. There appears to be little banking panic among retail customers. It’s true that banks are not lending, but not because they lack deposits.

I’m not nearly as worried about the FDIC as Blinder and Hubbard are. And Blinder has a massive conflict: he’s the vice-chairman of the company which runs CDARS, a financial instrument designed solely to get around FDIC deposit limits.

It’s also a good idea to implement massive deposit insurance before there are any bank runs — ie, now — rather than after the horse has bolted.

But there aren’t very many places for the horse to bolt to. The only place safer than a bank is probably Treasury bills: the last issue of 6-month bills came with an interest rate of 1.12%, compared to the 3% to 4% that banks are offering on FDIC-insured 6-month CDs, which are essentially the same credit as T-bills.

Are there so many people with deposits over the new FDIC limit that they can cause a run on the bank? Under the old FDIC limits, Wachovia had quite a lot. And Treasury knows something we don’t: after all, they have real-time information on deposit outflows.

Barry Ritholtz is already including the full amount of government guarantees in his cost of the bailout; it does seem that Treasury is piling on the government guarantees with rather too much in the way of zeal and reckless abandon. If Paulson still had credibility, I’d trust that the deposit guarantee was necessary. But as it is, I worry that it might have some nasty unintended consequeces: it could act, for instance, as a message to banks that other banks really are in trouble and shouldn’t be lent to.

Credit markets are all about having faith in your counterparty; when there’s a government guarantee, you don’t need that faith, and it disappears, as Douglas Adams might say, in a puff of legislative action. If credit markets are to get moving again, we need to encourage banks to start trusting each other. Government guarantees make that less, not more, likely.

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