Should the true costs of insuring deposits of up to £75,000 be made clearer?

Andrew Hewitt.

Deposit insurance schemes guard against bank runs by reducing or removing individual depositors’ incentives to withdraw their funds if they believe their bank to be in trouble. They help protect depositors but they risk also protecting risky bank business models by removing depositors’ incentives to avoid riskier banks. What can be done about this? In the past the answer was sometimes to make small depositors bear part of the risk through “co-insurance”. This was proven not to be credible. In this blog I consider some of the options available, including the risk-based levies currently being introduced in the EU and elsewhere, and increased transparency, drawing on recent literature on the saliency of tax in consumer choices.

The global financial crisis that began in the late 2000s prompted authorities across the world to increase deposit insurance limits. This was to maintain and restore public confidence in the banks and avoid bank runs. In the US, the limit jumped from $100,000 to $250,000 (bringing it back to roughly five times per capita income). The EU made a threshold of €100,000 (or its national currency equivalent) mandatory for its then 27 members, five times the previous minimum requirement of €20,000, and about four times GDP per person across the EU (just over three times GDP per person in the UK). In this way, policymakers relearnt the lessons of 1930s America, when deposit insurance coverage of around nine times GDP was introduced to restore confidence during a calamitous banking crisis in which more than 10,000 banks had failed. This is shown in the chart below.

Sources: Financial Services Compensation Scheme, Financial Services Authority, Office of National Statistics, Bureau of Economic Analysis, Federal Deposit Insurance Corporation, author’s calculations.

As well as increasing coverage levels, authorities across the world removed “co-insurance”. Until 1 October 2007 the first £2,000 of each UK deposit was fully protected, but the depositor would stand to lose 10% of everything above that amount, up to the threshold of £35,000 – the co-insurance element. The idea was supposedly to give even small depositors an incentive to assess the credit-worthiness of banks. But UK authorities found out the hard way that this is not realistic, and such schemes defeat their own purpose because they don’t change incentives for depositors to withdraw their funds at the first sign that a bank may be in difficulties. That’s why on that day in the autumn of 2007, when faced with the real prospect of a run on Northern Rock by its depositors, the FSA did away with co-insurance, with immediate effect. Co-insurance is now no longer a feature of any G20 or EU system.

But who is paying for all of this? In almost all jurisdictions, deposit insurance is paid for collectively by some combination of the shareholders, creditors, employees, and customers of banks in the system through levies imposed upon the banks themselves. But amongst the biggest direct beneficiaries are those fortunate enough to have deposits now covered by the higher limits. As banks’ levies are based on the amount of insured deposits they take, they could pass increased insurance costs directly on to those insured depositor beneficiaries, by reducing interest rates. But it is questionable if this happens in practice: there is a great deal of cross-subsidisation in the UK retail bank account market, and a glance at the “best buy” tables suggests banks tend not to differentiate between insured and uninsured deposits in the interest rates that they offer.

This raises a number of problems. First of all, there is a big distributional problem. Only about 15% of UK households have more than £13,500 in savings accounts; less than 5% have more than the new £75,000 limit that has applied since 1 January 2016 (to maintain equivalence with €100,000). The proud owner of a high-spec luxury sports car worth £75,000 would be surprised if he didn’t have to pay to insure his new toy against theft just because he had found what he considered to be a reasonably secure garage in which to park it.

But it gets worse. It is widely recognised, including by deposit insurers themselves and with empirical evidence in support, that unpriced deposit insurance of this type can cause significant “moral hazard”.

This is because, with deposit insurance, especially with no co-insurance, insured customer depositors have no need to balance risk and reward as there is no risk to their funds whichever bank they choose. So they would demand no “risk premium” for depositing funds with banks with riskier business models. This can encourage risky lending. The fact that deposits were covered by deposit insurance (or, at least, the perception that they were covered) helped the Icelandic banks, for example, to raise deposits at home and in other European countries to fund a risky and ultimately unsuccessful business model.

A way to realign risk and reward is through risk-based levies (RBLs), which require riskier banks to pay higher levies than safer banks. They have been in place in the US since the 1990s and are now mandatory across the EU, except where other existing measures (such as the UK bank levy) are in place. A risk-based system has number of advantages. In particular it should, if passed on to insured depositors, remove the risk premium they may otherwise demand if their deposits were uninsured

But it is very hard to ensure that RBLs reflect the actual risk posed by each bank to the deposit insurer, particularly where target levels for the aggregate size of the deposit insurance fund are not themselves risk-based. And even if levies were accurate, cross-subsidisation could mean that costs are not passed on to depositors.

Maybe introducing a direct, risk-based “deposit tax” payable by insured depositors would help. But this would be politically difficult, and costly to administer. Instead, deposit insurance levies expressed as percentage of covered deposits could be framed as a notional tax on deposits. Banks, not depositors, would still have to pay the levies. But if banks were required to prominently to display in marketing material and on bank statements the interest rate reduction caused by the deposit insurance levy, depositors might be nudged into better choices by making the levy more “salient”. Evidence from an economics laboratory experiment suggests that consumers spend 30% less on a given product when the sales tax element of the price is made transparent. Another study, this time in the real world of a US grocery store, found that tax transparency reduces demand by about 8%.

Such transparency would allow depositors to see at glance how much it is costing them to keep their money at a particular bank. If levies were risk based, it could prompt them to switch to a less risky bank. This would be good for competition. Firms with the least ability to absorb losses, and so least ability to avoid calling on the deposit insurance arrangements if they fail, might struggle as a result. They might react in the short-term by increasing deposit rates in a bid to keep depositors or attract new ones, as weak firms often do. This underscores the importance of having an effective resolution regime in place, allowing for orderly exit with minimal impact on customers.

But insensitivity to deposit interest rates would likely mean that any change would be gradual. In 2013 there was at least £145bn of deposits in accounts with more than £5,000 that paid a rate of interest equal to or less than the BoE base rate, despite better deals being available.

However, even if levies are not risk-based and some depositors are not sensitive to interest rates, increased transparency could still have a positive effect over time. It could help and encourage banks to pass on levies directly to their wealthier insured depositors. It could make savers more conscious of the existence of deposit insurance, and – if they don’t require an insured safe haven – that they could avoid paying the “tax” by moving funds out of banks and directly into capital markets. All of these things could have downsides. But increasing transparency in this area is worth further consideration.

This post was written whilst Andrew Hewitt was working in the Bank’s Resolution Policy Division.

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