Bank Regulation and Deposit Insurance

The subject of government bank regulation is intimately intertwined with that of government deposit insurance. If the government is to insure bank deposits, it should also have some say in the risks that insured banks are allowed to take, otherwise it would leave itself wide open to unlimited potential losses. John H. Kareken (in this issue) comes close to arguing that banks without government deposit insurance could provide satisfactorily safe transactions accounts. I would go one step further and argue that government deposit insurance is not just unnecessary but actually undesirable. Banks that offer transaction deposits are supposedly subject to an "inherent instability problem" that makes them prone to self-realizing depositor panics. Traditionally, transaction deposits are denominated as a fixed number of currency units, while the assets corresponding to these deposits are mostly finite-term securities or commercial loans. If depositors all want their money at once, the banks simply do not have it. To the extent that their assets are marketable, the banks can sell them off to meet withdrawals with only minimal losses. But if there is a run on the banking system as a whole, the banks' scramble for funds could conceivably drive interest rates up and asset prices down to the point at which the banks are actually insolvent simply because of depositor fears that they might fail. To the extent that bank assets consist of poorly marketable commercial loans, they are even more exposed to the risk of runs. This inherent instability problem is the most commonly cited argument for government deposit insurance and the careful government regulation it entails (or ought to entail). However, the money market mutual fund (MMMF) is a recent market innovation that completely solves this inherent instability problem of the payments system. As Kareken points out in his paper, MMMFs, like all mutual funds, are run proof since their obligations to their investors are simply pro rata shares in the current market value of the