Federal Deposit Insurance Corporation
Chairman
L. William Seidman
Office of Research
and Statistics.
Director
Wm. Roger Watson
Editor
John F Bovenzi
bAlitorist] Committee
Predenck S. Cams
Alan S. MuCall
Lynn A. Nejezchleb
Administrative
Manager
Den a Voesar
Eilitorin] Secretary
Cathy Wright
Design and Production
Design and Printing
Unit
The views expressed are
those of the authors and
do not necessarily reflect
official positions of the
Federal Deposit In
surance Corporation Ar
ticles may be reprinted
or abstracted if the Bank
ing Review and author
are credited. Please pro
vide the FDIC's Office of
Research and Statistics
with a copy of any
publications containing
reprinted material.
Single-copy subscriptions
are available to the
public free of charge. Re
quests for subscriptions,
back issues or address
changes should be mail
ed to: FDIC Banking
Review, Office of Cor
porate Communications.
Federal Deposit In
surance Corporation.
550 17th Street, N.W.,
Washington, D.C. 20429.
FDIG
Bankin:
view
Spring/Summer 1989
Vol. 2, No. 1
Bank Intermediation, Bank Runs, and Deposit Insurance page 1
by Arthur .!. Murtnn
This article examines the reasons why the government provides deposit insurance and how the
provision of deposit insurance can improve economic performance. It is argued that the primary
reason for deposit insurance is to promote financial stability by preventing bank runs. Deposit
insurance, however, may allow excessive risk-taking and there exists a trade-off between the
benefits of financial stability and the costs of possible misallocation of resources associated with
excessive risk-taking. The terms of this trade-off depend on the availability of alternatives to bank
deposits as sources of liquidity, the importance of bank lending activities, and the difficulty
associated with monitoring bank asset values and risk-taking. Finally, alternatives to deposit in
surance and reforms of deposit insurance are considered.
Should the $100,000 Deposit Insurance Limit Be Changed? page 11
by Frederick S. Cams
In considering how to harness market forces to better control bank risk-taking, it often is recom
mended to alter the £100,000 statutory limit on deposit insurance coverage. The most common
suggestion is to reduce the scope of coverage—and thus promote "depositor discipline"—either
by lowering the dollar amount of coverage per deposit or restricting coverage to particular deposit
classes. Occasionally, however, it also is suggested that deposit coverage be expanded in order
to facilitate methods of failure resolution that may elicit stronger discipline from nondeposit
creditors. This article considers the merits of proposals to enhance market discipline through
changes in the statutory limit on deposit insurance coverage.
Forbearance: Practices and Proposed Standards page 20
by Dean Forrester Cobos
Forbearance is a word with different meanings to different people. Because in recent years
forbearance often has been associated with the delayed closure of insolvent institutions, it has
become a dirty word in many places. However, there are many forms of forbearance that have
long been accepted supervisory practices. Forbearance is not something to be avoided under
all circumstances. This article discusses appropriate uses of supervisory forbearance.
Recent Developments Affecting Depository Institutions page 29
by Benjamin B. Christopher
Chairman
L. William Seidman
Office of Research
and Statistics.
Director
Wm. Roger Watson
Editor
John F Bovenzi
bAlitorist] Committee
Predenck S. Cams
Alan S. MuCall
Lynn A. Nejezchleb
Administrative
Manager
Den a Voesar
Eilitorin] Secretary
Cathy Wright
Design and Production
Design and Printing
Unit
The views expressed are
those of the authors and
do not necessarily reflect
official positions of the
Federal Deposit In
surance Corporation Ar
ticles may be reprinted
or abstracted if the Bank
ing Review and author
are credited. Please pro
vide the FDIC's Office of
Research and Statistics
with a copy of any
publications containing
reprinted material.
Single-copy subscriptions
are available to the
public free of charge. Re
quests for subscriptions,
back issues or address
changes should be mail
ed to: FDIC Banking
Review, Office of Cor
porate Communications.
Federal Deposit In
surance Corporation.
550 17th Street, N.W.,
Washington, D.C. 20429.
FDIG
Bankin:
view
Spring/Summer 1989
Vol. 2, No. 1
Bank Intermediation, Bank Runs, and Deposit Insurance page 1
by Arthur .!. Murtnn
This article examines the reasons why the government provides deposit insurance and how the
provision of deposit insurance can improve economic performance. It is argued that the primary
reason for deposit insurance is to promote financial stability by preventing bank runs. Deposit
insurance, however, may allow excessive risk-taking and there exists a trade-off between the
benefits of financial stability and the costs of possible misallocation of resources associated with
excessive risk-taking. The terms of this trade-off depend on the availability of alternatives to bank
deposits as sources of liquidity, the importance of bank lending activities, and the difficulty
associated with monitoring bank asset values and risk-taking. Finally, alternatives to deposit in
surance and reforms of deposit insurance are considered.
Should the $100,000 Deposit Insurance Limit Be Changed? page 11
by Frederick S. Cams
In considering how to harness market forces to better control bank risk-taking, it often is recom
mended to alter the £100,000 statutory limit on deposit insurance coverage. The most common
suggestion is to reduce the scope of coverage—and thus promote "depositor discipline"—either
by lowering the dollar amount of coverage per deposit or restricting coverage to particular deposit
classes. Occasionally, however, it also is suggested that deposit coverage be expanded in order
to facilitate methods of failure resolution that may elicit stronger discipline from nondeposit
creditors. This article considers the merits of proposals to enhance market discipline through
changes in the statutory limit on deposit insurance coverage.
Forbearance: Practices and Proposed Standards page 20
by Dean Forrester Cobos
Forbearance is a word with different meanings to different people. Because in recent years
forbearance often has been associated with the delayed closure of insolvent institutions, it has
become a dirty word in many places. However, there are many forms of forbearance that have
long been accepted supervisory practices. Forbearance is not something to be avoided under
all circumstances. This article discusses appropriate uses of supervisory forbearance.
Recent Developments Affecting Depository Institutions page 29
by Benjamin B. Christopher
Bank Intermediation
Bank Intermediation,
Bank Runs, and
Deposit Insurance
by Arthur J. Murton*
This article examines the
reasons why the government
provides deposit insurance
and how the provision of deposit in
surance can improve economic per
formance. It is argued that the
primary reason for deposit insurance
is to promote financial stability by
preventing bank runs. Deposit in
surance, however, may allow ex
cessive risk-taking and there exists a
trade-off between the benefits of
financial stability and the costs of
possible misallocation of resources
associated with excessive risk-taking.
The terms of this trade-off depend on
the availability of alternatives to
bank deposits as sources of liquidity,
the importance of bank lending ac
tivities, and the difficulty associated
with monitoring bank asset values
and risk-taking. Finally, alternatives
to deposit insurance and reforms of
deposit insurance are considered.
Banking and the Cost
of Bank Runs
Deposit insurance is a form of
government intervention into the
marketplace. Government provision
of deposit insurance is predicated on
[he existence of social benefits
associated with insurance of bank
deposits. The major social benefit
that deposit insurance is intended to
provide is the prevention of
widespread bank deposit runs and
the damage that they cause.1'2 In
order to justify deposit insurance, it
is necessary to specify why and how
bank runs impose social costs. Much
attention has been focused, par
ticularly through the efforts of Fried
man and Schwartz (1963), on the
damage to the money-supply process
caused by bank runs. This channel
requires a systemic run to currency
and a failure of the monetary authori
ty to offset the collapse of the money
multiplier. Bernanke (1983), while in
no way dismissing the importance of
the monetary channel, argues that
bank runs impose an additional cost,
the loss of credit intermediation.
The argument for deposit in
surance put forth here follows Ber
nanke by focusing on the credit-
allocation role of banks. Bank runs
are costly, it is argued, in part
because runs can disrupt or destroy
an important conduit of investment
funds in the economy. This argument
therefore focuses on the role of
banks as intermediaries in the
economy.
Bernanke's framework was built on
two foundations. The first is the
seminal article by Diamond and Dyb-
vig (1983). Banks are a special class
of intermediaries, distinguished
primarily by their funding of illiquid
assets with liquid liabilities. This
feature is critical to both the produc
tive role of banks and their suscep
tibility to damaging bank runs. The
second foundation is the literature
that focuses on banks as a
mechanism to overcome information
problems associated with certain
assets.
For purposes of this discussion,
"bank" will refer to a stylized entity
which issues liabilities that are
redeemable at par either on demand
or after some short maturity and
holds assets that are illiquid because
banks have private information
about the quality of the assets. The
first part of the discussion will focus
on an important and controversial
question: namely, whether there is
essential interaction between the
liability and asset sides of the bank,
or conversely, whether it is in
nocuous, in theory and in practice,
to separate the two sides of the
balance sheet. The second part of the
discussion focuses on the
characteristics of bank assets.
* Arthur J. Murton is a financial economist
in the KUIC's Office of Research and Statistics.
The author is grateful to Fred Cams, Chris
James, and Lynn Nejezchleb for helpful discus
sions and comments
1 See Edwards and Scott (1979) for a
thorough discussion of the reasons for govern
ment intervention into depository institutions
and an assessment of the appropriateness of
various forms of intervention.
2 Government action is often triggered by
the desire to help a particular group that is
perceived to be disadvantaged in some way.
In the case of deposit insurance, the argument
is that there are people who are relatively un
sophisticated financially who should have easy
access to a safe means for both mailing
payments and for storing wealth. (See Gorton
and Pennacchi (1988).) If this were the sole
reason for government intervention, it would
seem that the current system represents a
sledgehammer approach, and that either lower
deposit insurance coverage or a more limited
alternative form of protection would be
appropriate.
Bank Intermediation,
Bank Runs, and
Deposit Insurance
by Arthur J. Murton*
This article examines the
reasons why the government
provides deposit insurance
and how the provision of deposit in
surance can improve economic per
formance. It is argued that the
primary reason for deposit insurance
is to promote financial stability by
preventing bank runs. Deposit in
surance, however, may allow ex
cessive risk-taking and there exists a
trade-off between the benefits of
financial stability and the costs of
possible misallocation of resources
associated with excessive risk-taking.
The terms of this trade-off depend on
the availability of alternatives to
bank deposits as sources of liquidity,
the importance of bank lending ac
tivities, and the difficulty associated
with monitoring bank asset values
and risk-taking. Finally, alternatives
to deposit insurance and reforms of
deposit insurance are considered.
Banking and the Cost
of Bank Runs
Deposit insurance is a form of
government intervention into the
marketplace. Government provision
of deposit insurance is predicated on
[he existence of social benefits
associated with insurance of bank
deposits. The major social benefit
that deposit insurance is intended to
provide is the prevention of
widespread bank deposit runs and
the damage that they cause.1'2 In
order to justify deposit insurance, it
is necessary to specify why and how
bank runs impose social costs. Much
attention has been focused, par
ticularly through the efforts of Fried
man and Schwartz (1963), on the
damage to the money-supply process
caused by bank runs. This channel
requires a systemic run to currency
and a failure of the monetary authori
ty to offset the collapse of the money
multiplier. Bernanke (1983), while in
no way dismissing the importance of
the monetary channel, argues that
bank runs impose an additional cost,
the loss of credit intermediation.
The argument for deposit in
surance put forth here follows Ber
nanke by focusing on the credit-
allocation role of banks. Bank runs
are costly, it is argued, in part
because runs can disrupt or destroy
an important conduit of investment
funds in the economy. This argument
therefore focuses on the role of
banks as intermediaries in the
economy.
Bernanke's framework was built on
two foundations. The first is the
seminal article by Diamond and Dyb-
vig (1983). Banks are a special class
of intermediaries, distinguished
primarily by their funding of illiquid
assets with liquid liabilities. This
feature is critical to both the produc
tive role of banks and their suscep
tibility to damaging bank runs. The
second foundation is the literature
that focuses on banks as a
mechanism to overcome information
problems associated with certain
assets.
For purposes of this discussion,
"bank" will refer to a stylized entity
which issues liabilities that are
redeemable at par either on demand
or after some short maturity and
holds assets that are illiquid because
banks have private information
about the quality of the assets. The
first part of the discussion will focus
on an important and controversial
question: namely, whether there is
essential interaction between the
liability and asset sides of the bank,
or conversely, whether it is in
nocuous, in theory and in practice,
to separate the two sides of the
balance sheet. The second part of the
discussion focuses on the
characteristics of bank assets.
* Arthur J. Murton is a financial economist
in the KUIC's Office of Research and Statistics.
The author is grateful to Fred Cams, Chris
James, and Lynn Nejezchleb for helpful discus
sions and comments
1 See Edwards and Scott (1979) for a
thorough discussion of the reasons for govern
ment intervention into depository institutions
and an assessment of the appropriateness of
various forms of intervention.
2 Government action is often triggered by
the desire to help a particular group that is
perceived to be disadvantaged in some way.
In the case of deposit insurance, the argument
is that there are people who are relatively un
sophisticated financially who should have easy
access to a safe means for both mailing
payments and for storing wealth. (See Gorton
and Pennacchi (1988).) If this were the sole
reason for government intervention, it would
seem that the current system represents a
sledgehammer approach, and that either lower
deposit insurance coverage or a more limited
alternative form of protection would be
appropriate.