Unintended consequences and deposit insurance

Save the banks! Save the depositors! We need to protect them, so let's increase the level of deposit insurance from $100,000 to $250,000. There is no question that increasing the deposit insurance for bank clients will stem withdrawals from risky banks to the Treasury market. Any reduction in deposit outflow will allow for less delevering of the banking system which will reduce the credit crunch. Unfortunately, the overall impact on markets will not be clear as the investors react to the change.

First, the increase in deposit insurance will allow poorly managed and capitalized banks to continue to exist. At 8,000, there are still too many banks in the US. If depositors are protected, we will allow some of these institutions to continue when there may be a reason for closure. Of course, the government may want to slow and control this process and not have the extra fright from more bank failures. Nevertheless, there are some institutions whose aggressive practices are responsible for this mess and they should not be allowed to fall under the insurance umbrella

Second, we are going to see more cross border moves in banks because of changes in deposit insurance polices across countries. Ireland has insured all deposits which will clearly cause some savvy depositors to move money to Ireland to take advantage of the benefit. These insurance scheme will accentuate the risk differs in banks. Risk shifting will move from the private institutions to government institutions.

Three, the increase was necessary because money market mutual funds were given insurance by the Treasury Department so they would not break the buck. If the Treasury was willing to give insurance to money funds for a three month period, these funds were given a better insurance deal than banks. The banks, of course, would want a better deposit insurance scheme.

The actions of the government will cause portfolio rebalancing effects which may shift money to areas which were not originally intended. The funds which are left out of any insurance scheme will be at a disadvantage to all others and will move to those places where there is a guarantee. It is not clear that this is what the government wants to happen.