Deposit insurance is one of the most misunderstood – and also most dangerous – forms of government intervention into the financial system.
Let’s start with the common misconception that deposit insurance is an industry-operated affair independent of the government.
In the UK, deposit insurance is provided by the Financial Services Compensation Scheme (FSCS). To quote from its website:
“The FSCS is the UK’s statutory fund of last resort for customers of financial services firms. This means that FSCS can pay compensation to consumers if a financial services firm is unable, or likely to be unable, to pay claims against it. The FSCS is an independent body, set up under the Financial Services & Markets Act 2000 (FSMA).”
It also explains that the FSCS is funded by levies on firms authorised to operate by either of the Prudential Regulation Authority or the Financial Conduct Authority.
So the FSCS is notionally independent and the guarantees are financed by levies on participating firms.
However, this does not mean that deposit insurance is in any way a free-market phenomenon: it is explicitly the creature of legislation and participating firms are compelled not just to join, but to join on dictated terms. This is rather like having a system of compulsory car insurance and, moreover, a compulsory system that mandates the exact terms (including the pricing) of the car insurance itself – compulsory one-size-fits-all.
This should set off alarm bells that there might be something wrong with it.
And how do we know that its designers designed it properly? We don’t.
In fact, we know that they couldn’t possibly have designed it properly, as any rational insurance system would tailor the charges to the riskiness of clients, include co-insurance features and other incentives to moderate risk-taking, have charges that would evolve over time in response to changing market conditions, and so forth. This is insurance 101.
This is not how deposit insurance works, however.
Most of all, any rational system would have the product delivered by the market, not by some jerry-built contraption dreamt up by committees of legislators and regulators who have neither the knowledge nor the incentive to get it right. One also might add few if any of these people have any experience in or understanding of the industry they are meddling with, but let’s move on.
It then occurred to me that perhaps my kids are right and I am too cynical – maybe Father Christmas and the fairies do exist: one should keep an open mind – so I checked out the FSCS website to have a closer look at their system. What I found was a masterpiece of gobbledegook that I highly recommend to other connoisseurs of regulatory gibberish:
Backward ran sentences until reeled the mind. My favourite bit is the explanation of the levy calculation that does not explain how the levy is actually calculated.
All this said, the banks rather like deposit insurance because it gives them a great marketing tool: bank with us and your money is safe because we are members of the deposit guarantee scheme, and you will get your money back even if we happen to fail.
They also like it because they can game the system – taking extra risks and offering higher deposit rates than they would otherwise be able to get away with – in effect, exploiting the risk-taking subsidy created by deposit insurance and passing the extra risks to the fund itself.
But surely, if the banks like the system, they would create one themselves if the government didn’t create it for them? No. Were this true, the banks would have done exactly that many years ago, and there would have been no ‘need’ for the state to have intervened to do it for them. The fact is that they didn’t.
The reason they didn’t is because the service that deposit insurance provides to the retail customer – reassurance or confidence – is better provided in other ways, most notably, by pursuing conservative lending policies and maintaining high levels of capital. And the reason for this is simply that deposit insurance introduces an additional layer of moral hazard and governance headaches that can be avoided if the banks self-insure via moderate risk-taking and high levels of capital.
This should come as no surprise. True confidence does not come from “you can trust us if we screw up because someone else will bail you out” but from “you can trust us because it is demonstrably in our interest to make sure we don’t screw up”. Deposit insurance is an inferior confidence product – one might even say, a confidence trick.
We can also look at this another way. Suppose that a group of banks attempted to set up a scheme similar to the current one, of their own free will and with no government intervention. They would soon realise that the scheme was not viable – no bank would want to be liable for the risks the others were taking, with no means of controlling those risks. So it would never get off the ground – and the current system only got off the ground because the state imposed it.
In short, deposit insurance is not a creature of the market but a creature of the state, and a decidedly inferior one at that. It is, indeed, a classic instance of that regulatory Gresham’s Law by which state intervention causes the bad to drive out the good. Where have we seen that before?