The Economics Book

CONTEMPORARY ECONOMICS 321

In 1933, President Roosevelt

signed an act that guaranteed bank

deposits. Bank runs were reduced,

but some believe that such deposit

guarantees increase risk taking.

By the afternoon of

March 3, scarcely a bank

in the country was

open to do business.

Franklin D. Roosevelt

In the history of modern

capitalism, crises are the

norm, not the exception.

Nouriel Roubini

Stephen Mihm

a national bank holiday to prevent
people from withdrawing their
savings. Alternatively, the central
bank can act as the “lender of last
resort” to banks. However, there is
often uncertainty about what the
central bank will do. Deposit
insurance is ideal, because it
ensures that patient people will
not participate in a bank run.

Alternative views
There are alternative explanations
for the existence of banks. Some
focus on banks’ investment role.
The bank can gather and keep
private information about
investments, choosing between
good and bad investments, and
reflect this private information
efficiently through the returns it
offers to savers. It can offer a
return to depositors that is only
possible if it carries out its
monitoring role well.
In 1991, US economists Charles
Calomiris and Charles Kahn
published an article that took issue
with the Diamond–Dybvig view.
They argued that bank runs are
good for banks. In the absence of
deposit insurance, depositors have
an incentive to keep a close eye on
how well their bank performs. The

threat of a run also provides an

incentive to the bank to make safe

investments. This is one side of

so-called “moral hazard” (pp.208–

09). The other side is that managers

will take riskier decisions than they

would if there were no deposit

insurance. The problem of moral

hazard became apparent in the

1980s US savings and loan crisis,

when mortgage lenders were

allowed to make riskier loans and

deposit insurance was enhanced.

US bank failures rose.

Recent crises

It is hard to prove which of these

two views about bank runs is

correct, since in practice neither

explanation can be isolated. There

are many forms of moral hazard in a

bank. A shareholder may encourage

risk taking because all he can

lose is his investment. A bank

employee, offered bonus incentives,

may take risks because all that is

at stake is a job. One commonly

proposed solution to moral hazard

is tougher regulation.

Recent bank crises have usually

begun with investment losses.

Banks are forced to sell assets to

reduce their borrowing. This leads

to further falls in asset prices and

further losses. A run on deposits

follows, which can spread to other

banks to become a panic. If the

whole banking system is affected,

it is called a systemic banking

crisis. In the 2007–08 crisis, runs

occurred despite the system of

deposit insurance. A large part

of the recent crisis took place

institutions that are not regulated

as banks, such as hedge funds, but

were doing much the same as a

bank: borrowing for short terms

and lending for long terms.

Many countries strengthened

their deposit insurance policies

during the financial crisis that

began in 2007–08. This is

understandable, since bank failures

can have a devastating effect on

the real economy, breaking the

connection between people with

savings and people who need to

invest. The moral hazard argument

is like fire prevention, in that it is

concerned with protecting the

economy from a future crisis.

However, the midst of a crisis may

not be the time to be talking about

preventative actions. ■