Deposit Insurance is a Gamble

HoldemIn a letter to the Economist on May 3rd, Mark Neale, Chief Executive of the UK’s Financial Services Compensation Scheme (the country’s deposit insurance provider), chastised the magazine for its view of deposit insurance as a “corrosive trend” in the state’s involvement in finance.

Mr. Neale points out that deposit insurance is not funded by the government, but is financed through levies paid by the banking system. He further claims that “all insurance creates some moral hazard”, implying that deposit insurance is not radically different from other forms of insurance.

In these claims he is only half correct. The issue with deposit insurance is not one of who pays for it. It is a question of whether such insurance can actually exist in the first place.

In a wonderful little section in Human Action, Ludwig von Mises outlines the distinction between class events and case events. Cases are individual and unrelated occurrences, such as playing a football match or fighting a war. We have much knowledge about the protagonists, but of the outcome we know not much In distinction, there exist classes of events where we know very little about the individuals that comprise a class but the whole of them behave in a similar fashion. A roll of dice provides a good example. Whether snake eyes result from any given roll is relative unknown, but over a series of rolls we know that this outcome should occur roughly once out of every 36 times.

This distinction is important as only class events can be insured. Insuring bank deposits is not included in this category.

When one buys life insurance, the product does not make the individual live a more risky life. He doesn’t try to die a little earlier so that his life insurance product will pay off. In fact, if all goes well he would never have to use the product, but it is there just in case. (And if he lived his whole life, there would be not much need for a life insurance policy as the premiums paid in will amount to more-or-less the policy payout.)

Life insurance does not create moral hazard. Deposit insurance definitely does.

When your bank account is insured your criteria in selecting a bank change drastically. No longer are you worried about prudent financial management, but rather your aim is to maximize a sure bet. Since deposit insurance will pay you out whether your bank is liquid or not, you aim for the bank offering you the best bang for the buck. The lowest fees is a common criterion, as is the highest rate of return on the deposited funds. Banks compete on both these margins by taking on greater and more (hopefully) profitable risks. The problem arises when the risks don’t pay off, as was the case in 2007-08 when many bank investments turned sour.

Bank deposit insurance is unlike any other insurance product. In fact, it’s a complete misnomer to call it “insurance” at all. Like rolling the dice, it’s a gamble. And when investments turn sour, it’s a pretty bad one at that.

(Originally posted at Mises Canada.)

Comments

  1. I think this post is way off base.

    While, I think it would make more sense if the depositor purchased deposit insurance directly, either through a program offered by the bank, or via their own insurance agent, saying this sort of thing is uninsurable is nonsense.

    Plus, having life insurance can make a person’s life more risky. I can’t believe the author is not familiar with people killing themselves so that their family could get the proceeds (or the family murdering the insured).

    When you hire a contractor, you should see if they have insurance, if they don’t they may be cheaper to hire, but also more risky not having a 3rd party to go after should something happen.

    Same thing, if you’re choosing a bank, you want to know if you’ll be indemnified should they mismanage your funds and you cannot get them back.

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