Should the deposit insurance/lender of last resort functions be privatized?

Economics Economics Questions
1

First of all, let me clarify that I am no economist, so please be patient with me if I say something stupid [:D]

I know that most austrians advocate 100% reserve banking as the best way to eliminate the moral hazard problems associated with fractional reserve banking. However, it looks extremely unlikely that 100% reserve banking will be established any tme soon.

Thus, my question is the following: Barring the implementation of 100% reserve banking, can we solve the moral hazard problem by privatizing the deposit insurance and lender of last resort functions and letting competitive institutions provide those functions?

The reason I ask this is that it is clear to me that the “deposit insurance” currently provided by the FDIC does not deserve to be called insurance. The fact that the FDIC tipically runs large losses indicates to me that the risk posed by banks is seriously underpriced, meaning that this risk is heavily subsidized by the state, which in turn contributes to moral hazard. Thus, the immediate question is: Is there a way to adequately price the deposit insurance risk? It is clear to me that this is impossible for as long as this function is provided by the state, but in theory, if you privatize this function, the market would adequately price this risk thus removing moral hazard. The way I see this, this function would be akin to the function furnished by reinsurers in relation to the insurance market.

My sense is that privatizing the deposit insurance function (currently performed by the FDIC) along with the closely related function of lender of last resort performed by the Fed would nicely eliminate, or at least substantially reduce moral hazard. The deposit insurers would regularly audit the banks they insure, and price the risk of their unreserved deposits according to each bank’s lending and investment practices. And, as the premiums charged by the private insurers would more closely reflect the real level of risk of each bank (as opposite to the current, undiferentiated pricing provided by the FDIC), banks would have an incentive to keep their risk under control.

So, has this proposal ever been made by anyone? Does it make any sense at all or I am just out of my mind?

Thanks in advance,

2

This is actually false, very doubtful at least.

Anyway these are serious moral hazards. As far as I know a from of deposit insurance on the free market only existed as a function of clearinghouses, and they were indeed performed it much better than the current government schemes. The very idea of a lender of last resort however is only meaningful in a fiat money system. It cannot exist, the whole notion is meaningless in an unhampered market.

3

Thank you for the answer.

Maybe I misspoke when I said “most austrians”…I know Huerta de Soto does support 100% reserve banking, and I believe Thomas Woods also prefers it. Now, what type of arrangement do austrians not supporting 100% reserve banking advocate in order to deal with the moral hazard?

In relation to the LOLR function, maybe I am missing something: my sense is that in a free market, if a bank faces a crisis, it would ask its deposit insurer for assistance. If the deposit insurer determines this is indeed a liquidity crisis, it would lend the money, otherwise it would let the bank go bankrupt and pay up the deposits to the public.

In any case, I have not seen the idea of privatizing these functions anywhere, and wonder whether anyone actually considered it at any time.

4

They usually support totaly free banking regulated only by the market and contract law.

A bank run can happen due to too low reserves, insufficient assets and not enough liquid assets. Strictly speaking deposit insurance is not viable, because these risks are largely controlled by the bank, hence uninsurable.

What clearinghouses did first of all is strict conditions on membership. Member banks had to have adequate assets and capital to be solvent. Then if a solvent bank suffered a drain on reserves and faced a run fellow banks lent to it through the clearinghouse to give it time to increase liquidity from its assets thereby avoiding the run. If insolvent badly run banks faced a run they were left to go under avoiding the moral hazard.