Eli Dourado

Mutual fund banking

In a post on moral hazard in the banking system, Megan McArdle writes,

Nor do I find the central story of how the FDIC induced this moral hazard very compelling. Supposedly, ordinary depositors don’t bother to check the soundness of their banks because they don’t actually have skin in the game.

Anyone making this argument cannot have met many ordinary depositors. If you stripped away my mother’s FDIC protection, she wouldn’t do any better of a job at evaluating Citigroup’s finances.

(HT: Scott Sumner. See his reply here.)

I don’t know Megan’s mother, but I suspect that this is correct. The problem with Megan’s argument, however, is that it is a partial equilibrium analysis. It is an extrapolation of what would happen if the FDIC were shut down and nothing else changed. A better way to approach the issue is to look at what changes the elimination of the FDIC would induce in the banking system: what would be the new general equilibrium?

Without FDIC protection, Megan’s mother and millions like her would probably not feel comfortable lending money to banks as we know them today, which would be prone to runs. Depositors have fixed claims, and banks have variable assets. Without deposit insurance, when people start to suspect that their bank’s assets have declined (that the bank is no longer solvent), they rush to withdraw their deposits. Because the bank is leveraged, this causes insolvency, whether or not the bank was insolvent in the first place.

An alternative to this model is described by Cowen and Kroszner in their 1990 Cato Journal article, Mutual Fund Banking: A Market Approach. They argue that in the absence of deposit insurance, depositors would seek alternatives to traditional banks that do not suffer from the tendency to experience runs. One such approach would be mutual fund banking.

We examine mutual fund banking as an alternative form of financial intermediation. Individuals would hold checkable deposits at financial intermediaries structured as mutual funds. Although the nominal value of depositor holdings would not be fixed, risk could be hedged through the choice of portfolios.

Here is the money quote:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

If Cowen and Kroszner are right that something like this would evolve in the absence of deposit insurance, and I think they are, then moral hazard would be greatly reduced by eliminating the FDIC, even if ordinary depositors are incapable of performing a significant monitoring function.