The EU is contemplating adopting a European-wide deposit insurance program.  The deposit insurance program opponents acknowledge it ends bank runs, but argue against deposit insurance saying it promotes excessive risk-taking.  Given the design of the global financial system, is their reason for rejecting deposit insurance true?

No!

Hans-Werner Sinn, Professor of Economics and Public Finance at the University of Munich, laid out the opponents’ case for deposit insurance promoting excessive risk-taking.

First and foremost, deposit insurance would induce irresponsible risk-taking on the part of banks. It would enable even the eurozone’s zombie banks to obtain savings deposits at will and use them to finance trash ventures worldwide.

Prior to their collapse in 2013, banks in Cyprus had to pay interest of 4% or more on deposits to compensate for savers’ fears of insolvency. Now just imagine savers bringing their savings to Cyprus and not having to worry about losing them, thanks to a European deposit insurance. Banks in Cyprus would be able to collect any amount of customer funds from anywhere in Europe by offering minimal risk premiums, allowing them to spin an even bigger wheel of fortune than they did in the past.

Some argue that this danger no longer exists, because the ECB is now supervising European banks. That is wishful thinking: no banking regulator will be able to prevent excessive risk-taking once a deposit insurance has been established.

Professor Sinn is right about banking regulators.  They have never been able to prevent excessive risk-taking.  This has proven to be true regardless of whether or not there is deposit insurance.

Fortunately, our financial system is not designed to rely on banking regulators preventing excessive risk-taking.  By design, this is the role for the market.  By design, it is recognize the market has expertise in all the ways banks take on risk and can exert discipline to prevent excessive risk-taking.

For example, nobody expects the banking regulators to understand the complex derivative positions JP Morgan’s London Whale put on or how these positions transitioned from being a hedge to being a proprietary bet.  However, everyone expects the market and its experts to be fully capable of assessing these derivative positions and understanding when they become a proprietary bet.  The story of the London Whale involves the market confirming these expectations.

However, for the market to perform its role, it needs transparency into each bank’s current exposure details.  Without this level of disclosure, there is no reason to think the market could exert discipline (if you cannot see the risk, you are unlikely to push to minimize the risk).  It is the absence of this disclosure and not deposit insurance that lets banks take on excessive risk.