Will Expanding Deposit Insurance Coverage Prevent Bank Runs?

The answer is NO, as I explain below.

The Senate has passed the modified bailout package.  The TARP is still the central part of the package.  As I argued earlier, attempts to use of asset management companies to deal with financial crises failed in many countries including Japan.  The package does not have anything to encourage or force recapitalization of the financial sector, which is necessary to end the crisis.  The package does not provide any mechanism to deal with failures of systemically important non-banks, such as Lehman: the government just hopes they will not fail anymore.  Thus, as far as the part that is relevant for the financial system stabilization, the modified package is not a significant improvement over the original bailout plan that many criticized and the House rejected.

On addition to the package this time is the expansion of deposit insurance coverage.  It increases the coverage limit of deposit insurance from $100,000 to $250,000, and allows FDIC to request the government to cover unlimited amount of losses.  The protection of bank liabilities is another tried and failed policy to deal with the financial crises in many countries.

Again, my example comes from Japan.  Japan established an explicit deposit insurance system long before the banking problems started.  After the Japanese banks started to suffer from the bad loans in the 1990s, the Deposit Insurance Act was revised in 1996 to temporarily lift the coverage limit of ¥10 million (about $95,000) per person per bank.  Thus, all deposits were insured without limit.  The limit was supposed to be reintroduced on April 1, 2001, but it was later postponed to April 1, 2002, and even then it was only gradually lifted (first for time deposits, and then for ordinary deposits). One can argue the full insurance on deposits in Japan prevented traditional bank runs (people literally rushing to bank branches to withdraw their deposits), but depositors nonetheless shifted their deposits from clearly troubled banks to relatively healthy banks.  Many people shifted their savings from private sector banks to the postal savings, which was government-owned, or into cash.  In this sense, there was a “silent” bank run.

More importantly, the full insurance of deposits did not prevent the banking crisis in Japan in November 1997, when several banks and security houses (including Hokkaido Takushoku Bank, a major bank, and Yamaichi Securities, one of the big four security houses) failed and the interbank loan market (call market) collapsed.

The experiences from other countries, including Japan, suggest the bailout package is not likely to work.  If the alternative was a complete meltdown of the financial system (whatever it means), L-shape stagnation like Japan would be certainly more attractive.  We may soon consider Japan in the 1990s as a successful case of responding to a large negative asset price shock.  The economy did not grow, but many people maintained their quality of life.  It was not like the Great Depression.  Could Japan have done better?  Yes.  Can the US do better?