IT IS a simple but brilliant idea. Pooling risks—the essence of insurance—allows people and businesses to protect themselves from disaster. The insured have the incentive to buy homes or build business, knowing that they will be saved from the worst outcome. That enables the economy to grow faster and everyone to enjoy a higher standard of living.
But one assumption is crucial. The pool of risks must be genuinely diversified, so that only a small proportion of policyholders will be making claims at any one time. If not, then the insurer could go bankrupt.
When it comes to insuring whole industries, that is a problem. In America bank deposits and company pensions are protected through sector-wide schemes, funded by a levy on those that participate. The problem, as the Federal Deposit Insurance Corporation (FDIC) and the Pension Benefit Guarantee Corporation (PBGC) have found, is that banks and pension funds engage in herd-like behaviour.
Banks compete in similar lines of business, lending against commercial or residential property or (in the late 1970s) channelling money to developing nations. That other banks are doing the same thing tends to breed confidence, rather than caution. Indeed, executives may come under pressure if they are losing market share in a popular area. When banks lend money so that people can buy assets, the prices of those assets rise; in turn, that makes the banks more confident about their original lending decision. As a result when the market turns, a lot of banks can have similar problems.
Pension funds tend to invest a large part of their portfolios in domestic equities—in other words, in other companies that are members of the insurance scheme. When stockmarkets fall, the assets of all pension funds decline together. Worse still, investors then tend to switch into government bonds, pushing down yields. Thanks to the discounting mechanism, that raises the present value of the funds’ liabilities. The industry can switch from massive surplus to massive deficit within a few months.
A further problem, that applies especially to the banks, is moral hazard. If deposits are insured, there is little incentive for a bank’s customer to assess its creditworthiness and every incentive to take the highest rate on offer. In other markets, a higher rate would imply higher risk. In turn, that may force bank executives to take more risk in order to earn back what they are paying depositors; after all, the insurance scheme will pick up the tab if things go wrong. Dealing with that danger requires a complex system for regulating the banks, and even then, bankers may outwit the regulators.
These problems can be very slow to emerge and you could argue that deposit insurance has worked brilliantly in America for 70 years. Nevertheless, as it faces its latest test, the system looks fragile. The FDIC had $45.2 billion in its fund at the end of the second quarter. That compares with $78.3 billion of assets in the 117 “problem banks” it has identified. More worryingly, it represents only a little over 1% of the more than $4 trillion of insured deposits in America. This is not much of a cushion against a system-wide problem.
The FDIC can raise more money from its member banks. But what is the best way of doing so? If it charges all banks equally, the prudent end up subsidising the reckless. However, a risk-based levy might prove an intolerable burden for an already-troubled bank.
Over at the PBGC, the 2007 accounts appeared to reveal a healthier position, with a reduced deficit of $13 billion. But that was when equity markets were relatively robust; this year’s falls will have driven the deficit sharply wider again. The collapse of a big car company would provide a huge test.
Taxpayers in effect stand behind such schemes, just as they eventually had to stand behind America’s savings and loan industry. But a government bail-out would surely weaken confidence in America’s financial system, especially as the government is also trying to stabilise the housing market and has an unspecified commitment to support the country’s investment banks.
Unsurprisingly deposit- and pension-insurance schemes tend to be popular, given the harm to losers when banks and retirement funds fail. The example of the 1930s, when a lack of public confidence in the banks contributed to the Depression, is impossible to forget.
But such schemes may breed a degree of complacency that there will always be someone else around to fix any problems. The costs of that complacency are now becoming clear.