Now, let's study deposit insurance in some greater detail. We said that someone, I will put it, someone makes payments to depositors, if and when the bank fails to do so for whatever reason. Now, again, let's suppose that the someone is a private insurer, an insurance company. Well, we can say this is not such an unrealistic situation. If we looked at the insurance business we can see that sometimes insurance companies. Because you can say, "Well, what if this private insurer does not have enough money?" Then, the problem of a run goes up to the level of the insurer. So, previously people would run on the bank. Now, they would run on the insurance company. We can say, "Well, some of the insurance companies they engage in reinsurance or they come together in great pools, and then they sort of buy insurance for their own policies." But you can see that you can climb up. And the problem is that all these private insurers they can have some preferences in their activities and they have to make money. And therefore, although the details of the ways of running their businesses may be quite different but the overall approach and the reaction of depositors is very similar. So, if the bank fails why couldn't the insurance company fail? So this situation is not realistic because it brings the problem at the next level and actually its scale goes up. And therefore, it became clear to the people who started to think about this that it should be some kind of an institution that is not private and that is clearly the government. Why is that, that as soon as the government steps in then the situation is resolved? Well, first of all, let's step back for a moment and see the background against which the whole discussion of deposit insurance first occurred in the United States. That was around the year 1932. By that time it had been already almost close to more than two years of the Great Depression. And although, some of the huge stock market collapses were already over but the economy was not recovering. And the main reason to that as was studied later and the people who studied that among them is the former chairman of the Fed, Ben Bernanke. They noticed that there were massive bank runs, waves of bank runs. So for many reasons the money was not travelling in the system as freely and as efficiently, it was sort of braked by this rusty mechanism that was later labeled as the growing cost of credit intermediation. And the main reason was that as soon as there was a point at which you could start recovering, then unfortunately you would see that the people, let's say entrepreneur would start to recover. But when they were let's say borrowing some money and then they were working hard and they were making enough money and they would even overcome the situation of let's say deflation and still they had been able to do something. But what if anything happens to the bank through which they make payments? So, the inability of the system to ensure normal money circulation was extremely detrimental to the recovery of the whole economy and that is why reviewers said, "Well, we have to do something with that. These waves of runs they prevent us from getting out of this huge hole." Again as I mentioned in the previous episode, there were arguments against that. Some people said, "Well, if we do provide federal deposit insurance. So basically we would say to all the depositors of the bank, 'If your bank fails to make a payment then the government will make this payment to you.' So your money is safe. It is covered. It's under a very reliable umbrella, if you will." But then people said, "And what if these people still come at point one?" Because the main idea of deposit insurance was to make sure that the people who saw a nightmare would say, "Well, wait a minute. I'm insured." So that was just a nightmare. I don't have to rush into a bank. I will come at point two when I need the money. So that was the key idea. And some of the arguments against that said, well, people who didn't come at point one and then the government fails. And if the government fails that's a huge problem. But those who lead here and solved the idea, they said, "You know what? If we just declared that the government stands behind people would not rush in point two." And again, as legends in this case go that involved in there was a really thin margin but the appearance of deposit insurance one and in 1933 the government declared that all deposits in the economy in United States were covered up to $2,500. Well, now these amounts run in six digits. But what is important is that indeed people did calm down. They didn't show up at point one in our terminology and the economy started to recover very quickly. Well, it was just let's say an incentive, it was just a push. It did not fully recover in fortune until the World War II, but sort of the trend was broken and it was broken successfully. And now deposit insurance is institutionalized in the majority of countries where capital markets exist, and the depositors in these countries are happy and supported and protected by their governments. And you can see that the only great risk to the workability of deposit insurance lies in the idea that let's say, what if someone does not trust their government? Well, this is sort of a strange idea in most developed countries, but it's not so strange in some developing countries. And the acute polemics about that's normally would go around the fact that what if the government fails to deliver? Well, so far, as far as I'm concerned, I don't know the stories of a massive failure on delivery on deposit insurance and that is what supports the idea and makes it very efficient in global capital markets. So, we analyzed Federal Deposit Insurance. We've seen that it's been successful. It does provide some stability. It plays an extremely important positive role in the efficiency of capital markets. So it's time for us again to lean against our armchair and say, "Well, we did it." Now as always in this course, and as oftentimes if not always in finance, this is just a temporary relief. Unfortunately, even such a powerful and efficient tool as deposit insurance has a significant systemic problem built in it. And we will see that the deposit insurance as such if it's offered without specific regulatory terms or regulatory limitations imposed by force on financial institutions, it is likely to fail or it is at least likely to become extremely and prohibitively costly. We will analyze these problems in the next episodes of this week.
