Followup to an idea provoked by Crisis Economics

Followup to an idea provoked by Crisis Economics

This is a followup to an idea I recently posted provoked by Roubini and Mihm's Crisis Economics.

Is there another lurking moral hazard?

This was prompted by James' comment. James asked about the terms of the insurance, and I answered that it's basically "if bank X dies, mail checks to its account holders".

But that made me think, isn't there a moral hazard there? When a bank seems soon to fail, what keeps bankers and customers from colluding to inflate the amount of the deposits? Then insurance pays the customer money that he never actually lost, and the customer promises to secretly split it with the banker.

It's a type of fraud, so it'd be illegal. But we'd want structural protections too.

Perhaps the answer is to set the terms so that very recent deposits are not covered, or are less covered. Alternatively, recent deposits might be charged higher rates.

Can the premium rates zoom high?

I said that the premiums were set by auction, and the auction recurs. Presumably as it becomes clear that a bank will fail, the bids quickly rise to rates that clear out the accounts in the time remaining.

But this would hardly be fair to depositors. Deposits need to at least be held at previous rates for long enough for a consumer to see the new prices and possibly leave.

Why is banking different than most consumer decisions?

This was prompted by Scott's comments.

We trust consumers to make their own decisions on many purchases and services. Arguably we should trust them much further. So why shouldn't we ditch all government intervention, even as minimal as I proposed, and just leave it all to individual consumers' judgement?

Some reasons:

Banking is a credence good

Opening a bank account isn't like buying gas (a search good). It's not even like buying a car (an experience good). It's a credence good - you don't know whether it's bad till it burns you.

(Setting aside the fact that because of the govt, banking consumers don't actually get burned, taxpayers do)

Banking does not alert the consumer

Buying a car, because it obviously costs you a fair chunk of money, alerts most reasonable consumers to carefully gather information and weigh their options.

Putting the first $100 into a bank account does not. Neither does the next single check you put in, and so forth. So there's at least a "frog in boiling water" factor.

There's also the fact that, by their very nature, banks try to assure customers that they are extremely secure. That's why they have all that expensive furniture. Clearly this successfully reassures many people, and being reassured is the opposite of being alerted.

You could say that pages of legal documents alert the consumer. Sure, but that only goes so far. Even car purchases, my example of a very alert purchase, are felt to require lemon laws that restrain or override the legalese "agreement".

The consumer will lose an obfuscation arms-race

It should come as no surprise that the financial community can create enormous amounts of obfuscation that conceal far more than they reveal. Non-experts should not be required to penetrate it.