Saturday, September 15, 2007

Annals of Moral Hazard (Northern Rock Edition)

by Tom Bozzo

Some of you might remember that during the savings and loan crisis of the 1980s, there were some runs on S&Ls whose deposits were insured through weak state systems.

Fast forward, and our friend Xtin was on the scene [*] of the run on England's Northern Rock, which is remarkable in part because England does have a deposit insurance system as part of the Financial Services Compensation Scheme [**]. However, the NYT account this morning leaves out a significant detail of the system in the following:
One reason Northern Rock customers may be nervous is that there is less protection for account holders in Britain than in the United States in case a bank fails. Deposits are insured up to £31,700, or about $64,000, compared with up to $100,000 in the United States.
The difference between £31,700 and $100,000 in covered deposits doesn't do much to explain the length of the lines at Northern Rock branches. The difference which might is that the FSCS only provides 100% insurance to £2,000. The next £33,000 on deposit is insured 90%, so customers with non-extravagant balances could find themselves out sums that might not be enormous, but which also might not be inconsiderable either.

One criticism of deposit insurance is that it takes away a depositor's incentive to put money in sound banks. This is a form of "moral hazard," and a coinsurance scheme like the FSCS is a common means of dealing with it — in this case, by having the depositor share some of the risk. I would argue that this isn't an especially damning critique, since the soundness of banks isn't easily observed, and it's facially ridiculous to suggest that there aren't gains from specialization in bank regulation.

Meanwhile, the anti-moral hazard design may suffer from an excess of cleverness by half or more, to the extent it induces depositors to behave as if they are uninsured and run on the bank, which works at cross purposes to rescue attempts such as the Bank of England's in this case.

[*] She snapped, at higher resolution (if you click through), a picture of the queue at one of the branches depicted in this Calculated Risk post on the story.

[**] I suppose "scheme" doesn't have the connotation of fraud or unsoundness it has in American English; we'd undoubtedly substitute the robust-sounding "System" for the trailing "S."

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