“Deposit Insurance: Addressing Its Moral Hazard Effect”
Remarks by Thomas M. Hoenig,
Vice Chairman of the U.S. Federal Deposit Insurance Corp. and
President of the International Association of Deposit Insurers
Presented to the
16th Annual IADI General Meeting and Annual Conference
Quebec City, Canada
October 11, 2017
Introduction
In the more than 40 years that I have worked in bank regulation and supervision at the FDIC and the
Federal Reserve Bank of Kansas City, as well as in monetary policy on the Federal Open Markets
Committee, I have had the opportunity to observe firsthand the sense of security that deposit insurance
gives bank customers and creditors, with the objective of providing increased financial stability.
Unfortunately, I also have observed that deposit insurance, like any insurance system, inherently invites
its own abuse—moral hazard—that can cause unintended serious destabilizing effects on an economic
system.
While this experience does not provide me with the ability to outline a fail-safe solution to remedy this
conflict, it does offer me some insight on the matter that I want to share with you, my colleagues, here
today. Deposit insurance serves a most useful purpose, and I am not implying that its use be
discontinued because of the moral hazard side effects. I am suggesting, however, that we can mitigate
those effects if we, as insurers and supervisors, insist on good oversight through sound bank
supervision, reliable capital standards, and insurance pricing that holds banks accountable for the risk
profile they choose.
Moral Hazard
The principle function of deposit insurance is to promote confidence in the banking system and thus
financial stability. With such guarantees, depositors and creditors have no reason to run—not when
problems occur at banks other than where they place their money, nor when they suspect their own
bank might fail. However, such guarantees and the associated loss of market discipline, as a check
against institutional excess, invite systematic excessive risk-taking: the moral hazard effect.
While preventing runs on solvent institutions is desirable, preventing runs at any cost on all institutions,
even those that are insolvent, is not. The threat of failure serves to ensure that banks remain more
sensitive to risk, and it inhibits the industry from trending toward excessive risks. Without the discipline
provided by depositors and other creditors inclined to withdraw their funds when they suspect a bank of
being unsafe, banks have an incentive to take on such exposures. As this occurs, particularly in the
largest banks, the risk is often borne by the public, which backstops the financial safety nets.
Remarks by Thomas M. Hoenig,
Vice Chairman of the U.S. Federal Deposit Insurance Corp. and
President of the International Association of Deposit Insurers
Presented to the
16th Annual IADI General Meeting and Annual Conference
Quebec City, Canada
October 11, 2017
Introduction
In the more than 40 years that I have worked in bank regulation and supervision at the FDIC and the
Federal Reserve Bank of Kansas City, as well as in monetary policy on the Federal Open Markets
Committee, I have had the opportunity to observe firsthand the sense of security that deposit insurance
gives bank customers and creditors, with the objective of providing increased financial stability.
Unfortunately, I also have observed that deposit insurance, like any insurance system, inherently invites
its own abuse—moral hazard—that can cause unintended serious destabilizing effects on an economic
system.
While this experience does not provide me with the ability to outline a fail-safe solution to remedy this
conflict, it does offer me some insight on the matter that I want to share with you, my colleagues, here
today. Deposit insurance serves a most useful purpose, and I am not implying that its use be
discontinued because of the moral hazard side effects. I am suggesting, however, that we can mitigate
those effects if we, as insurers and supervisors, insist on good oversight through sound bank
supervision, reliable capital standards, and insurance pricing that holds banks accountable for the risk
profile they choose.
Moral Hazard
The principle function of deposit insurance is to promote confidence in the banking system and thus
financial stability. With such guarantees, depositors and creditors have no reason to run—not when
problems occur at banks other than where they place their money, nor when they suspect their own
bank might fail. However, such guarantees and the associated loss of market discipline, as a check
against institutional excess, invite systematic excessive risk-taking: the moral hazard effect.
While preventing runs on solvent institutions is desirable, preventing runs at any cost on all institutions,
even those that are insolvent, is not. The threat of failure serves to ensure that banks remain more
sensitive to risk, and it inhibits the industry from trending toward excessive risks. Without the discipline
provided by depositors and other creditors inclined to withdraw their funds when they suspect a bank of
being unsafe, banks have an incentive to take on such exposures. As this occurs, particularly in the
largest banks, the risk is often borne by the public, which backstops the financial safety nets.
In the United States, for example, the risks are borne by the healthy banks that fund the deposit
insurance system; by their customers who pay the costs through higher loan rates and lower deposit
rates; and ultimately by taxpayers, as we learned during the most recent financial crisis.
Since deposit insurance and government guarantees dramatically decrease the incentive of insured
depositors to monitor and discipline banks, the responsibility of preventing banks from imposing the
costs of excessive risk taking on the public safety net falls to other mechanisms, namely bank
supervisors and capital. Advocacy and support of both are important functions of the deposit insurer.
Counterbalances
With this in mind, I will focus most of the remainder of my comments on the role of bank supervision
and capital in counterbalancing the moral hazard dilemma. Historically, these tools, when used
effectively, have proved invaluable in assuring the banking sector is deserving of the public’s confidence.
In good times, however, they are often strongly opposed by the industry and, worse yet, they
sometimes go unused by both supervisors and insurers.
Paul Warburg, a German-born New York banker during the Great Depression and an early advocate for
the Federal Reserve System, observed this phenomenon as he commented on the public’s attitude
leading up to the Great Depression:
In a country whose idol is prosperity, any attempt to tamper with conditions in which easy profits
are made and people are happy, is strongly resented. It is a desperately unpopular undertaking
to dare to sound a discordant note of warning in an atmosphere of cheer, even though one
might be able to forecast with certainty that the ice, on which the mad dance was going, was
bound to break. Even if one succeeded in driving the frolicking crowd ashore before the ice
cracked, there would have been protests that the cover was strong enough and no disaster
would have occurred if only the situation had been left alone.1
Such attitudes can be as prevalent today as they were before the Great Depression. As they develop and
as the crowd noise drowns out calls for prudence, supervisors and insurers must force the crowd from
the proverbial ice. To fail in this duty, supervisors and insurers cannot hope to protect their insurance
fund from loss or to protect the economy and the public from the inevitable correction and its resulting
economic suffering. It is exhausting work, and it is most difficult to accomplish in the boom period just
before a crisis.
Having described the demands of the challenge, I am also confident that it can be managed. It requires a
commitment of bank owners in the form of equity capital. And it requires bank supervisors and insurers
to apply sound supervisory principles, anchored by the rule of law, irrespective of the enthusiasm and
the politics of the moment.
1 Paul M. Warburg, The Federal Reserve System, Vol I, Addendum II, “The Stock Exchange Crisis of
1929,” The Macmillan Company, 1930.
insurance system; by their customers who pay the costs through higher loan rates and lower deposit
rates; and ultimately by taxpayers, as we learned during the most recent financial crisis.
Since deposit insurance and government guarantees dramatically decrease the incentive of insured
depositors to monitor and discipline banks, the responsibility of preventing banks from imposing the
costs of excessive risk taking on the public safety net falls to other mechanisms, namely bank
supervisors and capital. Advocacy and support of both are important functions of the deposit insurer.
Counterbalances
With this in mind, I will focus most of the remainder of my comments on the role of bank supervision
and capital in counterbalancing the moral hazard dilemma. Historically, these tools, when used
effectively, have proved invaluable in assuring the banking sector is deserving of the public’s confidence.
In good times, however, they are often strongly opposed by the industry and, worse yet, they
sometimes go unused by both supervisors and insurers.
Paul Warburg, a German-born New York banker during the Great Depression and an early advocate for
the Federal Reserve System, observed this phenomenon as he commented on the public’s attitude
leading up to the Great Depression:
In a country whose idol is prosperity, any attempt to tamper with conditions in which easy profits
are made and people are happy, is strongly resented. It is a desperately unpopular undertaking
to dare to sound a discordant note of warning in an atmosphere of cheer, even though one
might be able to forecast with certainty that the ice, on which the mad dance was going, was
bound to break. Even if one succeeded in driving the frolicking crowd ashore before the ice
cracked, there would have been protests that the cover was strong enough and no disaster
would have occurred if only the situation had been left alone.1
Such attitudes can be as prevalent today as they were before the Great Depression. As they develop and
as the crowd noise drowns out calls for prudence, supervisors and insurers must force the crowd from
the proverbial ice. To fail in this duty, supervisors and insurers cannot hope to protect their insurance
fund from loss or to protect the economy and the public from the inevitable correction and its resulting
economic suffering. It is exhausting work, and it is most difficult to accomplish in the boom period just
before a crisis.
Having described the demands of the challenge, I am also confident that it can be managed. It requires a
commitment of bank owners in the form of equity capital. And it requires bank supervisors and insurers
to apply sound supervisory principles, anchored by the rule of law, irrespective of the enthusiasm and
the politics of the moment.
1 Paul M. Warburg, The Federal Reserve System, Vol I, Addendum II, “The Stock Exchange Crisis of
1929,” The Macmillan Company, 1930.