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Tuesday
Dec042012

The myth of safe banking

There is a pervasive assumption, implicit in many of the debates around the emergence of new financial services, that banks are paragons of stability and that deposit accounts are the gold standard for safe storage of value. After all, banks are heavily regulated, they have giant compliance and risk-management functions, and they are conservative by nature. What better place to store your money?

But this intuition gets the causation exactly backward. Banks have injected caution into their DNA and are subject to extensive prudential regulation because their business model is so risky. Banks accept short-term deposits and make long-term loans, rendering them constitutionally incapable of honoring a large number of withdrawals simultaneously. This is the worm in the bud of the fractional-reserve banking, and it haunts banks (and occasionally entire banking systems) during times of crisis.

You might think bank runs are largely a historical phenomenon. Actually, in America alone, a bank fails every week or so. You don’t hear about it the regulator has gotten very good at winding up banks (they can do it over a weekend), and because depositors are protected by insurance.

Now there have been howls of objection from those in the traditional banking industry that customers of Bluebird—a prepaid debit account offered by American Express in the United States—do not benefit from federal deposit insurance. Deposit insurance, they imply, is what distinguishes safe checking accounts from unsafe stores of value.

But again, this gets the logic backward. Deposit insurance emerged as a way to protect consumers from bank failures and to make such failures less common by reducing the incentive of individuals to participate in a bank run. As with any other form of insurance, deposit insurance protects against risk—in this case, the riskiness inherent in storing your money with an institution that is going to lend the vast majority of it to someone else. Were deposits risk-free ways of storing money, deposit insurance would be unnecessary.

For centuries, we have tolerated the fundamental instability of the fractional-reserve system and done our best to contain the risks associated with it. This is because our economies would grind to a halt without financial intermediation, of which banks are traditionally the engines. But just because you rely on something doesn’t make it safe.

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