Bank liability insurance is now ubiquitous and generally regarded as ‘best practice’ in banking regulation. But this is a recent phenomenon (Grossman and Imai 2010). Why did liability insurance of banks take so long to spread? Why did it arise, when, and where? What are the theoretical arguments for and against liability insurance? Has experience generally confirmed the consensus among policymakers that the benefits of deposit insurance exceed its costs? Is it possible that the consensus of deposit insurance being ‘best practice’ might be wrong?
In a new paper, we review the economic and political theories that seek to explain bank liability insurance and juxtapose those theories with the worldwide experience of bank liability insurance – including an analysis of the factors that led to its passage and expansion, as well as an analysis of its performance (Calomiris and Jaremski 2016a).
Broadly speaking, there are two theoretical approaches to explaining the creation and expansion of deposit insurance. The first is an economic approach grounded in potential efficiency gains from limiting bank runs (i.e. the public interest motivation). The second is a political approach grounded in the rising power of special interest groups that favoured insurance as a means to access subsidies (i.e. the private interest motivation).
Economic theories show how liability insurance may improve the efficient management of the banking system by reducing systemic liquidity risk. Government-provided deposit insurance eliminates the incentive for depositors to run a bank in anticipation of other depositors doing so. Despite that potential advantage, economic theories also recognise that there are costs of enacting liability insurance. Models of principal-agent conflicts such as Calomiris and Kahn (1991) show that demandable debt contracts allow depositors to subject banks to ‘market discipline’, which rewards good behaviour and punishes bad. Because insurance reduces the incentive for market discipline, it may increase fundamental insolvency risk as a consequence of greater conscious risk taking by bankers (i.e. moral hazard), or through an increase in the proportion of bankers who are incompetent managers (i.e. adverse selection). Therefore, whether, on balance, bank liability insurance reduces or increases risk in the banking system is an empirical question. Economic theories of liability insurance only make sense on economic grounds if the gains from liquidity risk reduction tend to exceed the moral hazard or adverse selection costs from reduced market discipline.
Political theory provides a separate theoretical basis for bank liability insurance. Political bargaining models identify circumstances under which the interests of particular groups within society (i.e. the beneficiaries of passing liability insurance) may succeed in securing its passage, even though liability insurance may be inefficient (Stigler 1971, Peltzman 1976, Becker 1983). Political models seek to explain why liability insurance may be chosen to favour certain groups in society even when it imposes large costs on society in the form of higher systemic risk for banks. In this context, liability insurance needs to be understood as part of an equilibrium political bargain achieved by a winning political coalition. Consequently, its function may vary across countries as a result of the differing political functions that it plays in different regimes and contexts.
To sort between the two types of theories, we review empirical evidence about, first, which factors are shown to be instrumental in creating bank liability insurance; and second, evidence about the consequences of passing insurance (that is, whether insurance has improved the stability of banking systems). We find that political theories are much more consistent with both sets of evidence.
First, the historical push for liability insurance in the US came from a coalition of small rural bankers and landowning farmers. The insurance of bank liabilities began as a US experiment in a handful of states during the early-to-mid 19th century. Liability insurance was confined to the North (New York, Indiana, Ohio, Vermont, Michigan and Iowa) where banks were limited by ‘unit banking’ laws to operate without branches. Unit banks were less diversified in their lending, and a system of unit banks was less able to coordinate banks’ actions in response to problems. Both aspects made unit banking systems less stable, and liability insurance was conceived as a means of reducing systemic risk while preserving unit banking limits. Unit banking limits had political appeal to landowning farmers who supported them as a means of tying banks to the local economy, and thereby making banks more willing to lend in the wake of adverse shocks to crop prices and land values. In contrast, banks in the antebellum South typically operated branch networks that were able to coordinate their responses to crises (such as the Panic of 1857), instead of adopting bank liability insurance schemes.
The early state liability insurance systems disappeared by the 1860s, either as a consequence of unsustainable losses and financial collapse (in New York, Vermont and Michigan) or as the result of Civil War tax policies that drove them out of existence (in Indiana, Ohio and Iowa).
A second wave of liability insurance systems arose in the early 20th century, in eight US states as the result of agrarian political support for unit banking. All of the eight systems collapsed within a few years of their founding. Despite those failures, US federal deposit insurance was enacted in 1933, again at the behest of unit banking champions such as Rep. Henry Steagall of Alabama, and over the objections of the Federal Reserve, the Treasury, the American Bankers Association, and President Franklin Roosevelt.
Worldwide, bank liability insurance remained a unique (and controversial) policy choice of the US until the late 1950s, but it spread rapidly throughout the world in recent decades, as shown in Figure 1. Today it is a nearly ubiquitous feature of banking regulation endorsed by influential cross-border institutions such as the IMF, the World Bank, and the EU.
Figure 1 Adoption of deposit insurance
Source: Demirgüç-Kunt et al. (2014).
Like the adoption of liability insurance in the US, the recent global wave of legislation creating and expanding insurance can also be traced to political influences. For example, deposit insurance is more common in countries with a more contestable political system (proxied, among other ways, by polity score) and with larger and more under-capitalised banks, as shown by Demirgüç-Kunt et al. (2008). Modern multilateral institutions such as the IMF, the World Bank, and the EU have also played a large role in using their political clout to encourage adoption of deposit insurance or expansion of its generosity.
The expansion of liability insurance has been generally associated with reductions in banking system stability. For the early 20th century US deposit insurance systems, we show in another recent paper that insured banks were able to attract deposits away from uninsured banks that were subject to market discipline (Calomiris and Jaremski 2016b). Insured banks were able to do so despite their increasing default risk profile. Similarly, empirical studies have uniformly found that modern deposit insurance encourages greater risk-taking, reduces market discipline, and negatively affects the growth of the financial system. For example, Calomiris and Chen (2016) find that exogenous external political pressures that lead a country to adopt or expand deposit insurance are associated with higher banking system leverage and higher asset risk (higher loans relative to assets). Therefore, although insurance is justified economically as a banks typically dominates the liquidity risk reduction, resulting in greater overall banking instability.
The political theories of liability insurance point to a major political advantage. It provides an effective means for a government to supply hard-to-trace subsidies to particular classes of bank borrowers. While some observers assume that banks have been the primary beneficiaries of liability insurance, and its main advocates, this has not generally been the case. In autocracies, insurance generally has been used to favour influential borrowers, which typically include industrial firms that participate in ‘crony’ networks. In democracies, insurance has been especially useful in favouring agricultural borrowers or urban mortgage borrowers with political clout. The support of rural landowners for liability insurance in the United States in the 19th and early 20th centuries is a prominent example. More recently, Calomiris and Haber (2014) show that the combination of liability insurance and other legislation worked together to encourage massive amounts of mortgage lending by banks and other protected intermediaries. Calomiris and Chen (2016) find that external political pressures expanding deposit insurance are also associated with a higher fraction of household lending (which mainly consists of mortgages).
Liability insurance can create a subsidy for banks (which they can pass through, in part, to borrowers) only if prudential regulation and supervision permit banks to take risks at the expense of the insurer. Thus, lax regulation and supervision are an important part of the political bargain that allows liability insurance to deliver subsidies to banks and targeted borrowers. It is not surprising, therefore, that there is substantial evidence that prudential regulation and supervision are subject to politicisation that can undermine their ability to reign in risk-taking by protected banks. In other words, regulatory failure is often a predictable consequence of the political bargains that give rise both to safety nets and prudential regulations. Barth et al. (2006) find that prudential requirements have no identifiable effects on systemic risk, and the extent of ineffective prudential rules is greater in more corrupt countries. These and other results suggest that complex regulation is motivated more by the desire to create opportunities for bribery than by its effectiveness in limiting excessive risk-taking. Brown and Dinc (2005) find that the regulatory recognition of bank losses and government interventions to close insolvent banks are unlikely to occur in an election year so as to avoid declines in credit availability.
We also consider whether alternative government policies that protect bank liabilities under some circumstances, such as times of high systemic risk (which we label ‘limited and conditional protection’), might be preferable to unconditional liability insurance or unconditional laissez-faire policy. Acharya and Thakor (2016) show that, in theory, limited and conditional protection is generally superior to either of the alternatives. Calomiris et al. (2016) show that ‘lender-of-last-resort’ policies that offered limited and conditional protection was a common and successful feature of many financial systems prior to World War II. However, like the failure of many countries today to adopt effective prudential regulation, the failure to implement limited and conditional protection, despite its historically proven record of success, has a simple political explanation – liability insurance is designed to create subsidies, not to limit systemic risk. As Yogi Berra might have said, if contemporary liability insurance systems had been designed to limit systemic risk, they wouldn't have been.
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