In the banking industry, the preferences of depositors and shareholders regarding the types of assets banks should invest in are often at odds. Depositors tend to favor safer, less volatile investments that offer lower returns, while shareholders typically seek out riskier investments that offer higher returns. This clash of preferences creates a complex dynamic that can lead to insolvency risk and jeopardize the safety of deposits.
The Conflict
The competing interests of shareholders and depositors create a conflict that is difficult to reconcile. Shareholders’ appetite for risk can put the bank at risk of insolvency, which in turn threatens the deposits of the bank’s customers. To mitigate this risk, depositors may demand lower returns or even withdraw their deposits, which can weaken the bank’s financial position further. This vicious cycle creates a challenging environment for banks, as they strive to balance the demands of their stakeholders and protect their financial stability.
The Solution
To align the interests of shareholders and depositors, Hendrickson proposes implementing multiple liability. This approach would require shareholders to compensate depositors in case of insolvency using up to twice the amount they had invested in the bank. This system incentivizes shareholders to prioritize the safety of deposits over risky investments that could lead to insolvency.
However, Hendrickson suggests an alternative solution that could be more politically feasible than abolishing federal deposit insurance. His proposal involves requiring people and institutions purchasing bank stock to make and hold deposits in the bank that are equal to the size of their equity purchase. These special deposits would be uninsured and held until the shareholder sells their stock. This approach would double the cost of a bank failure for shareholders and reduce the incentive to take excessive risks.
The Benefits
Hendrickson’s proposal has several benefits that make it an attractive alternative to traditional approaches. First, it allows market forces to move banks closer to alignment with uninsured depositors. This market-based approach utilizes shareholder incentives to prioritize the safety of deposits over risky investments, which can improve the bank’s financial stability. Second, the proposal allows the FDIC to continue insuring ordinary deposits while creating a separate class of uninsured deposits for shareholders. This approach offers a more nuanced solution that can balance the interests of different stakeholders.
Conclusion
In conclusion, Hendrickson’s proposal offers a compelling approach to addressing the issue of moral hazard in the banking industry. By aligning the interests of shareholders and depositors, this approach can mitigate insolvency risk and protect the safety of deposits. Moreover, the proposal utilizes market forces to incentivize shareholders to prioritize the safety of deposits, which can lead to a more stable financial system. As banks continue to navigate the complex dynamics of investments and insolvency risk, Hendrickson’s proposal offers a promising solution that warrants further consideration.
