Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition

Abstract

The argument, elaborated most convincingly by Milton Friedman (1962) is familiar to most if not all monetary economists. A fractional-reserve banking industry is inherently unstable. That is what the U.S. Congress acknowledged, if somewhat belatedly, when in 1913 it created a lender of last resort, the Federal Reserve System. But the system, once hailed by Irving Fisher as the guarantor of perpetual prosperity, was a terrible disappointment. It failed miserably the test posed by the depression of 1929 (or had the System done what it was supposed to do, what would have been the recession of 1929). There was an epidemic of bank failures in 1930-31. And in 1932-33 there was another epidemic, even more serious, which culminated in the banking holiday of 1933. So the Congress, having discovered that the industry it thought it had made panic proof was still panic prone, established another agency of government-the Federal Deposit Insurance Corporation, to insure certain of the liabilities of commercial banks operating within U.S. boundaries. And if it did not do as well by U.S. citizens as it might have, what it did was extremely helpful. To quote Friedman: . . federal deposit insurance has performed a signal service in rendering the banking system panic-proof . . .' (1959, p. 38). In his view, the In this paper we examine the equilibrium of the banking industry under various regulatory schemes. There are several critical assumptions: There are complete contingent-claims markets; the banking industry is a monopoly supplier of deposit services, but is otherwise 'small; banks are limited-liability corporations and are subject to bankruptcy reorganization costs. Among the more important conclusions are the following: (1) Absent deposit insurance and regulation, bankruptcy does not occur; (2) under an FDIC-type insurance scheme, the banking industry holds as risky a portfolio as regulations allow; and (3) a capital requirement, by itself, does nothing to forestall bankruptcy.

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