Cheap Capital? Call It Deposit Insurance

By Pollock, Alex J. | American Banker, June 5, 1991 | Go to article overview

Cheap Capital? Call It Deposit Insurance


Pollock, Alex J., American Banker


Cheap Capital? Call It Deposit Insurance

The first deposit-insurance fund in America was established in 1829 by the State of New York. It ran out of money after the banking failures of 1837-1841.

Oklahoma established the first deposit-insurance fund in the 20th century, in 1908. In 1909 it ran out of money.

So have many deposit-insurance plans since then, including numerous state funds and the Federal Savings and Loan Insurance Corp. These days, the Federal Deposit Insurance Corp. is doing the struggling.

The Cost of Bearing Risk

Banks often lose vastly more than anyone thought possible, causing the deposit-insurance funds to run out of money. It then becomes obvious that the price charged was insufficient to bear the risk.

Is it possible, in advance, to set the right price for bearing banking risk?

The best estimate of the right price is the market price. And the only way to find the market price is to create a market for the item in question.

Thus, many commentators believe that deposit insurance should be provided by private-market insurers. Unfortunately, only the federal government -- with its remarkable power to borrow and tax -- is really credible as a deposit insurer.

Voluntary Alternative

How can the market price be found when the supplier of the insurance represents the monopolistic, coercive power of the state? Two steps can help find this price:

* Make deposit insurance totally voluntary, with depository institutions free to purchase it or not, as they judge best, and customers free to do business with insured or uninsured institutions as they see fit.

* Raise the price of deposit insurance high enough to cause a reasonable percentage of depository institutions, say 10% to 20%, to drop out of the program.

How might a depository institution analyze the pros and cons of continuing to buy deposit insurance at any given price? Some undoubtedly would be convinced that they must buy deposit insurance no matter what the price and that their survival depends on the government keeping the price low. But this is only a way of saying they have no economic reason to exist.

High Cost of Public Confidence

A rational institution would ask itself: How high would our capital have to be to inspire sufficient public confidence so that we could operate without deposit insurance?

Many knowledgeable colleagues have tried to come up with modern answers. Usually, after considering the leverage of financial companies without government insurance and the historical record of banking, they tend to arrive at a required capital ratio of 10% to 15%.

These days, large finance companies have an average equity ratio of about 11.5%. In 1890, with no deposit insurance and no Federal Reserve, American banks had an average capital ratio of 24%.

Ratios to Suit the Times

In 1925, after the Federal Reserve's founding but still before deposit insurance, American banks had a 12% capital ratio. Let's suppose that 12% is a reasonable estimate of the required equity-to-assets ratio. Let us also assume, for the moment, a situation with no income taxes.

Supposing, therefore, that it would take an equity-to-assets ratio of 12% to function without deposit insurance. An average bank, with 8% capital, would reason thus:

To do without deposit insurance, we would have to double our capital to 12% of assets. On this new capital, we would have to earn about 14% -- but the first 8% would come automatically from investing the new funds in risk-free assets.

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