On bank runs and government guarantees

On deposit insurance

In the U.S., at the end of 2022, depositories had $19.2 trillion of deposits of which an estimated  $10.1 trillion were insured. In this commentary, Cecchetti, Schoenholtz, and Philippon ask “How can authorities balance the costs of runs and panics against the costs associated with moral hazard, while keeping in mind the potential financial burden on the public?” They suggest three possible ways to enhance deposit insurance:

• A higher insurance cap for small and medium-sized enterprises (SMEs) which lack professional cash managers. Policymakers can raise the deposit insurance cap for SMEs in a transparent way to ensure that most firms can meet their weekly (or perhaps monthly) transaction needs.
• New resolution rules that both “assure the continued operation of the bank and prioritize SME transaction accounts could limit the spillover effects of a bank run.”
• The possibility for the deposit insurer to offer banks an option to increase the insurance cap for an additional risk-based fee.

Last but not least:

[W]e also think that higher capital requirements should be part of the solution: if we require that banks increase the degree to which they finance their assets with capital (rather than deposits), the risk of runs and panics would decline even without raising the cap on deposit insurance.

The Future of Deposit Insurance
By: Stephen G. Cecchetti, Kermit L. Schoenholtz, Thomas Philippon – Brandeis University, New York University

On government loan guarantees

Instead of focusing on deposit insurance, Carletti et al. suggest a different form of government guarantee, namely a public loan guarantee. They use a model in which banks raise demandable deposits and grant long-term loans to analyze how the introduction of loan guarantees affects bank incentives and financial fragility. They find that:

• Loan guarantees reduce depositors’ run probability because the guarantees increase the range in which the bank can make the promised repayment. As a result, they reduce financial fragility.
• The introduction of loan guarantees improves banks’ monitoring incentives in many instances. “This finding arises both from a direct (positive) effect of loan guarantees and an indirect effect from the reduction in run probability. The result may differ only when the loan guarantee is shielded from bankruptcy costs. In this case, the presence of a loan guarantee reduces the sensitivity of the run threshold to changes in the underwriting effort. This last effect is negative as it reduces the benefit for the bank from increasing its effort, and it may dominate when banks are insufficiently capitalized.”

Loan guarantees, bank underwriting policies and financial fragility
Authors: Elena Carletti, Agnese Leonello, Robert Marquez
From: Bocconi University, ECB, University of California, Davis