Friday, June 18, 2010

Bank Runs and Deposit Insurance

Why do bank runs take place? Demand deposits are bank liabilities. When a bank suffers a loss, it becomes less able to meet all its obligations. To ensure that they are among the obligations that are met, individuals queue up at the bank demanding deposits be paid out. No one wants to be at the back of the line, as it is possible you get less than the full value of your debt claim. In fact, you might end up with nothing.

There are a handful of ways of preventing bank runs.
1. Suspension of Payments
If banks can suspend payments when a run becomes evident, they will have more time to figure out whether they can successfully meet all obligations. If they are solvent (i.e. can meet its obligations), there is no benefit to being the first in line when the bank opens back up so no run takes place. If it is insolvent, they will have to liquidate assets and pay each customer a fraction of debt claims. There is no need to run in this situation as there is no fear of ending up in the "back of the line."

2. Unlimited Liability Shareholders
If some shareholders have unlimited liability, there is no need to run. Those at the "back of the line" would be compensated by unlimited liability shareholders. So there is no reason to form a line.

3. Federal Deposit Insurance
The reasoning here is the same as #2 above. The difference is that it encourages shareholders to engage in riskier behavior, as they will not have to foot the bill if the bank fails.

4. Make debt claims equity claims.
The reasoning here is similar to that of suspension of payments by an insolvent bank. Rather than holding debt claims, customers have equity claims. And the price of an equity share fluctuates on the open market. So if the value of the claim falls, it does so across all shares simultaneously. Again, there is no "back of the line" so no one runs.

Money market mutual funds--where individuals hold equity claims--should be run-proof. Why then did the US Treasury Department guarantee MMMFs in September 2008?
The temporary guarantee program provides coverage to shareholders for amounts that they held in participating money market funds as of the close of business on September 19, 2008. The guarantee will be triggered if a participating fund's net asset value falls below $0.995, commonly referred to as breaking the buck.

The program is designed to address temporary dislocations in credit markets.
In other words, the government provided deposit insurance--which is typically justified as preventing runs--on run-proof deposits. Does anyone know another reason to insure equity claims?

1 comment:

Steven Horwitz said...

Check your premise. It's true there's no "back of the line" problem with MMMFs, but they can be "run" in the sense of being drained out. If folks didn't want to see the value of their hunk dip below "the buck," they might well have withdrawn funds from those accounts en masse. The fund can still pay (though at perhaps less than 1:1), but the damage that would have done to markets would have been potentially large.

The point is not to justify the insurance but to suggest that maybe this was not about protecting depositors as much as it was about protecting the funds and the folks who sold them the assets they invest in.