It has been 15 years since the $100,000 deposit insurance limit for eligible deposits at the Big Six banks and a host of other smaller federally-regulated deposit-taking institutions came into force. Inflation since then suggests the time has come to raise it. But we may want to think about other changes, too.
Canada has a fragmented deposit insurance system. In addition to the federal system managed by the Canada Deposit Insurance Corp.(CDIC), deposits of provincially incorporated institutions, like most credit unions and caisses populaires, are backed by their respective provincial deposit insurance corporations. Coverage limits in those systems range from $100,000 in Quebec to full coverage in the four western provinces.
The main argument for deposit insurance is that it reduces the risk that deposit-taking institutions will fail because of a bank run. That helps smaller institutions compete against the big banks because customers can confidently place deposits with them knowing their deposits are insured within the defined limits.
The main argument for limiting deposit insurance is to reduce moral hazard. Small depositors, who may not have the resources to assess the risks of different banks and take informed decisions about where to keep their money, get full protection. But people with deposits above the limits will have an incentive to make sure their financial institution isn’t taking on undue risk. Banks in turn have an incentive to avoid undue risks so as to continue to attract these large depositors.
Recent events raise questions, however, about whether deposit insurance really does reduce the risk of bank runs and whether there is a future for limited deposit insurance.
In 2017, Canadian mortgage-lender Home Capital experienced a bank run when depositors — uninsured and insured — withdrew their money after the bank was accused of misleading investors. It turns out even fully insured deposits will run if their holders become concerned about an institution’s viability.
As to the future of deposit insurance limits, the U.S. government’s swift response to last month’s bank failures was to stem contagion risk by covering all of Silicon Valley Bank’s deposits, not just the insured ones. But that undermines the very concept of limited deposit insurance and introduces moral hazard. Managers of banks and other deposit-taking institutions may be more tempted to take bigger risks now, betting that authorities will bail them out — after all, SVB wasn’t even considered a systemically important bank and it got a full bailout. Investors may assume the same and limit their oversight, thereby weakening market discipline.
Banks and other deposit-taking institutions pay premiums for their insurance coverage that are mainly based on the size of their deposit base. CDIC also imposes higher premiums on institutions that are judged to be more risky. However, none of our deposit insurance funds, from the CDIC’s to the provincial funds, are fully funded in the sense of having a pool of assets readily available to cover all insured deposits in the system. Far from it. So if we do increase the coverage maximums, we need to consider how large those deposit funds should be. Higher premiums represent capital that is not in use in the economy, but the obvious alternative of relying more on industry levies to pay for a failure after the fact could undermine the financial condition of surviving institutions at a time of stress.
Smaller deposit-taking institutions get big benefits from deposit insurance. Their customers receive the same protection big-bank customers do even though big banks pay more into the insurance funds. This is good from a competitiveness standpoint. But recent U.S. events are a reminder that smaller institutions can be systemically important as a group even if no single smaller bank is important on its own. If deposit insurance limits are increased materially, should smaller financial institutions face capital and liquidity requirements closer to those currently imposed on the six major banks? Should they also adopt the “bail-in” debt requirements imposed on the major banks so that if they fail more of the resolution cost is borne by the wholesale debtholders of the failing institution rather than the rest of the industry or — worse — the taxpayer? System stability would likely improve but competition would probably suffer: it’s not an easy balance. Policy makers should tread carefully and avoid an undue impact on competition.
Finally, no discussion about deposit insurance limits is complete without noting the presence of full deposit insurance coverage for provincially incorporated credit unions in B.C. and the Prairie provinces. That makes them more competitive, which is good for consumer choice, but it increases moral hazard. The western provinces may want to consider whether very large depositors at these institutions should continue to have their deposits fully insured.
Yes, it seems the fallout from SVB’s collapse has been contained for now, but the questions it raised about what to do about deposit insurance still need to be addressed.
Published in the Financial Post
Jeremy Kronick is director of monetary and financial services research at the C.D. Howe Institute, where Duncan Munn is president and Mark Zelmer, former OSFI Deputy Superintendent, is a senior fellow.