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Deposit Insurance is a Gamble

July 1, 2014 in Economics

By David Howden

In a letter to the Economist on May 3rd, Mark Neale, Chief Executive of the UK’s Financial Services Compensation Scheme (the country’s deposit insurance provider), chastised the magazine for its view of deposit insurance as a “corrosive trend” in the state’s involvement in finance.

Mr. Neale points out that deposit insurance is not funded by the government, but is financed through levies paid by the banking system. He further claims that “all insurance creates some moral hazard”, implying that deposit insurance is not radically different from other forms of insurance.

In these claims he is only half correct. The issue with deposit insurance is not one of who pays for it. It is a question of whether such insurance can actually exist in the first place.

In a wonderful little section in Human Action, Ludwig von Mises outlines the distinction between class events and case events. Cases are individual and unrelated occurrences, such as playing a football match or fighting a war. We have much knowledge about the protagonists, but of the outcome we know not much In distinction, there exist classes of events where we know very little about the individuals that comprise a class but the whole of them behave in a similar fashion. A roll of dice provides a good example. Whether snake eyes result from any given roll is relative unknown, but over a series of rolls we know that this outcome should occur roughly once out of every 36 times.

This distinction is important as only class events can be insured. Insuring bank deposits is not included in this category.

When one buys life insurance, the product does not make the individual live a more risky life. He doesn’t try to die a little earlier so that his life insurance product will pay off. In fact, if all goes well he would never have to use the product, but it is there just in case. (And if he lived his whole life, there would be not much need for a life insurance policy as the premiums paid in will amount to more-or-less the policy payout.)

Life insurance does not create moral hazard. Deposit insurance definitely does.

When your bank account is insured your criteria in selecting a bank change drastically. No longer are you worried about prudent financial management, but rather your aim is to maximize a sure bet. Since deposit insurance will pay you out whether your bank is liquid …read more


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