A Nobel Prize-winning economist’s view of bank runs and deposit insurance
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Deposit insurance and banking regulation—two topics in finance that often go under the radar—are having a moment in the spotlight following the joint awarding of the 2022 Nobel Prize in Economic Sciences to a trio of economists who conducted research into the role of banks in financial crises.
Among the three winners was Professor Philip Dybvig of Washington University in St. Louis. He co-authored the award-winning paper titled, “Bank Runs, Deposit Insurance, and Liquidity” with fellow awardee Douglas Diamond in 1983, effectively rewriting the economic literature around the anatomy and prevention of bank runs. Perhaps most importantly, the paper established the inherent tensions between savers and borrowers during moments of economic crisis.
“We focus on the rational aspects [of bank panics], and you can understand a lot by viewing the people as rational,” Dybvig told “Marketplace Morning Report” host David Brancaccio in an interview. “If you think other people are going to take their money out, it’s rational for you to take your money out, too.”
The following is an edited transcript of their conversation.
David Brancaccio: I want to imagine that somewhere in your home, professor, you’ve built some kind of shrine to the Federal Deposit Insurance Corporation. Given your study of bank runs, you must be a an FDIC fan.
Philip Dybvig: I have some buddies at the FDIC. So I guess that qualifies.
Brancaccio: It was a good invention, was it not?
Dybvig: Yeah, I think it was. And of course, the FDIC predates our paper. But I think that they are happy about our paper because it gives a more powerful raison d’etre than probably the original reasons for having it.
Brancaccio: I think a lot of people don’t know this, that in the economics field, your paper is so famous, even before the Nobel Prize, that some people will just call it, not even Diamond-Dybvig, they’ll just go, “You know, in Double D, they argue that…” Did you know that it’s called Double D for those in the know?
Dybvig: Yeah, so I hear “DD” more often than “Double D,” though, actually, I guess I’ve seen it written down. So I don’t know, I don’t know how people pronounce it to be honest. It’s a little bit like pronouncing names: you don’t know until somebody tells you.
Brancaccio: Well, we’ll call it DD. So, but this is the thing, Federal Deposit Insurance Corporation is partly a reaction to what happened early last century. Your paper is not until the 1980s. What was it about your paper that was so important, even though we already had federal deposit insurance?
Dybvig: So I’m not sure about the history exactly. But I think that a lot of the motivation of deposit insurance was for protecting consumers rather than stability. And what’s special about our paper is that it says it’s not denying necessarily that there are psychological aspects to bank panics. But we focus on the rational aspects and that you can understand a lot by viewing the people as rational. So it’s not that there’s this mass hysteria, people are whipped up into a storm, they go grab their money from the bank. Rather, it’s if you think other people are going to take their money out, it’s rational for you to take your money out, too. And that’s because if everybody else takes their money out, the banks are going to liquidate assets at a loss and they won’t have enough money left afterward to pay you.
Brancaccio: Because you notice when sometimes a run on the bank is brewing in one country or another, you have policymakers who are just urging the population to be calm, don’t take your money out, that would be in the wider public interest. And that may be true. But in terms of the individual, if there’s a risk of losing it, you don’t want to be last, you kind of want to be early.
Dybvig: That’s right. That’s exactly right. And that’s a rational thing. Now, it is the case that there are multiple equilibria. And you may persuade people to move to a better equilibrium. But that obviously is less powerful than a policy like deposit insurance that just removes the initial equilibrium.
Brancaccio: And it doesn’t just have to be deposit insurance, central banks can also provide a form of insurance that helps keep panic from building on itself.
Dybvig: So in our paper, we talked about three different types of mechanisms. Deposit Insurance is the most reliable. The second mechanism is the discount window. So people who are in a bank that’s experiencing a run expect that their bank won’t have to liquidate assets, because the Fed will let them borrow money at the discount window. The reason this is a little less reliable than deposit insurance, in general, is that people may also be concerned that the central bank has discretion. And the central bank may say, “No, this bank should not be bailed out,” and not lend to the bank. The third thing we talked about is so-called bank holidays, which basically say you just stop letting people take their money out. That of course causes huge disruption for the people who do have need for their money. So of the three, deposit insurance is the best.
Brancaccio: Yeah, but there are limits on FDIC insurance, federal deposits are only insured to a certain amount. Could it go further, in your view?
Dybvig: Yes, personally, I would prefer that the demand deposits were covered 100% because there’s still an incentive to run on the part that’s not insured. So maybe there’s a million dollars in the bank and only $250,000 is insured. If the bank were to fail, and it’d have to rely on the deposit insurance, then that $750,000 would be lost. And so if this person suspects the bank has any problems, and it doesn’t have to be a strong suspicion, then there’s a big incentive to move to a safer bank and take the money out, and that could lead to a run as well.
Brancaccio: Where do you come down, professor, on this idea in economics called “moral hazard,” where if you know there’s a kind of insurance, you know you’ll get bailed out if things go wrong, it can encourage riskier behavior. Do we just live with moral hazard or do you think about it as a balance?
Dybvig: So that’s actually an important part of bank regulation. We have bank examiners and monitoring by bank examiners. It actually plays the same role as loan covenants in private lending. So when you have a Deposit Insurance Fund, that means that the downside risk that might be taken on by the bondholders by the depositors will be borne instead by the Deposit Insurance Fund. And it’s very important to regulate banks in a way so that they’re not taking on too much risk.
Brancaccio: The other day, we reported on a survey of CEOs, more than 90% thought there would be a recession in the US next year, two-thirds of those thought it wouldn’t be a mild one, it would be something worse. From the perspective of your work, are there lessons you could share about what policymakers should do or not do if we get into tougher times and businesses and other institutions start to creak?
Dybvig: For me, I look at the current situation, and of course, maybe out of vanity, I would like to map every situation into our setting, but in that things can change. But at this point, I don’t see a financial crisis as part of that. I see kind of a garden variety big inflation, maybe stagflation that comes from, you know, big deficits and big spending. And I don’t necessarily see the financial system blowing up. But at this point, it seems like the people to ask are more on the macroeconomic side.
Brancaccio: I hear you when you say you don’t see the ingredients for a financial crisis when we’re talking about this macroeconomic stuff, inflation and higher interest rates in a recession that may be ahead. But between now and your and my retirement years, there could be a financial crisis brought on by something very unpredictable. Is there general advice for policymakers from the work that you’ve done that would apply to the next time we have to think about a financial crisis and responding to one?
Dybvig: Well, I think [there are] some obvious things we actually saw in 2008, which is that in the presence of runs, it still may not be too late to start thinking about deposit insurance. And I’m thinking, in particular, the deposit insurance that was put in place, in maybe a partial way but it probably helped, in the money market funds.
Brancaccio: What you’re saying is if there isn’t some kind of program to backstop participants in a particular financial arrangement, you can do it in-progress. Just because you didn’t set it up four or 10 years ahead doesn’t mean you shouldn’t consider it even during a crisis?
Dybvig: Yes. And I don’t take credit for this idea. I’m just looking at what they did and say, well, that’s interesting, there was no deposit insurance sitting there. And they put some in on the fly.
Brancaccio: So another question I wanted to ask you is, what’s a bank these days, professor? It used to be a place with a grand facade and a fancy lobby with piles of deposit slips. But with this world of financial innovation, crypto assets, and, you know, banks via app, how should we think about backstopping these new bank-like things if panic were to sweep through?
Dybvig: So I think right now, the people who get into these things are on their own, and they probably should be. But I also think that a lot of people who can’t afford to lose the money they lose are losing it and going to lose it. And I think the goal should be exactly what you’re saying. So it used to be the banks had a big facade, and that’s because they’re fragile, and they wanted to make you feel like they’re solid, and they were permanent. But the bank is not a facade, the definition of a bank should be based on the function, not on the location or the platform, or the technology that’s used. I think that you know, when people issue what are essentially securities in the crypto world, they should be regulated as securities. And if people set up crypto banks that are banks in terms of the function that they allow retail depositors to have a store of value and they can get their money back when they want to, and other things that banks do they make loans, to me that’s a bank and should be regulated like a bank. Now, there’s always a bit of catch-up in regulation of financial markets because there are a lot of smart, creative people out there and they will design things so that it will sidestep the existing definitions. So that’s something that’s going to be there.
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