Lin Shen, Junyuan Zou
Based on: “Intervention with Screening in Panic‐Based Runs.” The Journal of Finance 79.1 (2024): 357-412. DOI: https://doi.org/10.1111/jofi.13295
Bank runs have long posed a significant threat to the stability of the modern financial system. Runs occur when depositors, suspecting a bank’s financial instability, decide to withdraw their funds. This behavior can exacerbate other depositors’ fears, leading to a cascade of withdrawals. Despite ongoing efforts by financial regulators to curb these incidents, the specter of bank runs continues to loom. In early 2023, the collapse of Silicon Valley Bank underscored the persistent vulnerabilities in the U.S. banking sector.
To prevent bank runs, a government can provide deposit insurance, guaranteeing that depositors will get their money back if the bank fails. The idea is simple: if depositors know their money is safe even when the bank fails, they won’t panic and rush to withdraw money from the bank just because others are doing so. Such deposit insurance policies, either explicit or implicit, have been adopted by financial regulators worldwide. In most countries, banking institutions are required to participate in the deposit insurance scheme and to pay an insurance premium to fund the deposit insurance reserve. By requiring banks to participate, the current deposit insurance scheme covers depositors universally without giving them a choice to opt out.
Universal deposit insurance schemes have been effective in preventing bank runs and stabilizing financial systems over the past decades. However, they have faced criticism on two main fronts. First, deposit insurance is often subsidized, and implementing such expansive guarantee programs imposes substantial fiscal burdens on the authorities that underwrite the deposit insurance. This, along with other guarantee programs, can jeopardize the sustainability of sovereign debt and contribute to a sovereign debt crisis.
Second, these policies are vulnerable to moral hazard issues. With full guarantees in place, depositors have little incentive to monitor the financial health of banks. Consequently, banks may feel less pressure to manage their assets prudently, knowing that they are not at risk of depositor withdrawal. This lack of rigorous asset management can sow the seeds for future financial instability.
Recognizing the drawbacks of the current universal deposit insurance scheme, we propose an alternative: a voluntary approach to deposit insurance. Instead of enrolling all depositors as in the universal scheme, the proposed approach allows depositors to choose whether to pay an insurance premium for protection against bank failures. We show that the voluntary deposit insurance scheme addresses the two aforementioned drawbacks while remaining as effective as the universal scheme in preventing panic-induced bank runs.
How can the voluntary deposit insurance scheme be as effective as a universal scheme? The key lies in targeting the pivotal depositors. Depositors hold divergent views on a bank’s financial health. The most optimistic, confident in the bank’s solvency, would remain in the bank regardless of the availability of deposit insurance. The most pessimistic depositors, who find the insurance coverage insufficient, would withdraw their funds even if insurance is available. Since the availability of insurance does not alter the behavior of depositors with extreme views, excluding them has minimal impact on the bank’s stability. In contrast, depositors with intermediate views are crucial. They are uncertain about the soundness of the bank, and deposit insurance can significantly reduce their incentive to run. Including these depositors in the insurance scheme can therefore enhance bank stability. The voluntary scheme effectively leverages the divergence in perceptions among depositors. Non-pivotal depositors with extreme views opt out to avoid paying the insurance premiums, while pivotal depositors with intermediate views opt in as they find the insurance to be valuable.
Although only a small proportion of depositors choose to purchase deposit insurance, their impact on bank stability is substantial. All depositors, even those who opt out, recognize that the presence of the voluntary deposit insurance scheme discourages withdrawals by pivotal depositors, and therefore become more confident in the bank’s stability. The boost in overall confidence further reduces withdrawals and stabilizes the bank. This self-reinforcing loop of growing confidence makes the voluntary insurance scheme an effective and powerful deterrent against panic-induced bank runs.
How does the voluntary deposit insurance scheme reduce the fiscal burden on policymakers? On the one hand, the voluntary scheme excludes the non-pivotal depositors and thus operates on a smaller scale than the universal scheme. This allows policymakers to downsize the deposit insurance fund and save on scale-related costs. On the other hand, policymakers can charge higher insurance premiums under the voluntary scheme because it targets only the pivotal depositors who find the insurance valuable and are therefore willing to pay a high premium for it. The high premium not only reduces the fiscal burden but also effectively screens out pivotal depositors.
How is the voluntary deposit insurance scheme more robust to moral hazard than the universal scheme? In short, the voluntary scheme ensures that depositors maintain skin in the game when deciding whether to opt into the scheme. Under a universal scheme, depositors become inattentive to banks’ actions because they are universally shielded from adverse outcomes. Conversely, under a voluntary scheme, depositors must actively decide whether to purchase insurance by carefully evaluating the bank’s financial health and weighing it against the insurance terms. For instance, if a bank engages in excessive risk taking, even the pivotal depositors may decide the insurance is not worth the cost and choose to withdraw their funds from the bank instead. The potential for bank runs in response to a bank’s negligent oversight effectively monitors the bank’s actions, thereby reducing moral hazard.
In conclusion, although the current deposit insurance schemes and government guarantees come with significant fiscal burdens and moral hazard issues, the framework has remained largely unchanged and potential improvements underexplored. We propose an alternative approach: actively engaging depositors by making deposit insurance a voluntary option. This strategy not only mitigates the drawbacks of the existing universal scheme but also preserves its effectiveness in bolstering bank stability. To ensure the effectiveness of the proposed voluntary approach, policymakers must commit to not bailing out uninsured depositors; otherwise, all depositors would be effectively insured ex post.
