Why banks and insurers are regulated · RiskAtoms Academy

By the end you will be able to

1Explain the market failures behind the regulation of banks and insurers: runs, externalities and moral hazard.
2Show step by step how a run can break a sound bank, and how deposit insurance changes depositors' choices.
3Explain why a bank's failure costs far more than its own shareholders lose.
4Explain why safety nets create moral hazard, why capital rules and supervision come with them, and how insurers differ.

Why it matters

On 9 March 2023, depositors tried to pull about $42 billion out of Silicon Valley Bank in a single day. It was closed the next morning. No baker or airline needs a regulator to set its equity. Why do banks?

Core explanation

Where markets fail

L1.2.09: Regulators and supervisors showed who writes the rules: global standard setters agree them, and national authorities enforce them. This lesson asks the prior question: why have rules at all?

Most firms are left to choose their own risks. If a shop borrows too much and fails, its owners and lenders lose, and customers walk to the next shop. Economists accept regulation where there is a market failure: people acting sensibly for themselves produce a result that is worse for everyone. Banks suffer from three in particular.

1. Runs

A bank borrows short and lends long (L1.2.01: Commercial banks: the business model): deposits can leave today, loans repay over years. That works while depositors trust each other to stay. But deposits are paid first come, first served. If you think others will withdraw, the sensible thing is to withdraw first. Everyone reasons the same way, and a run becomes self-fulfilling. To pay, the bank must sell loans in a fire sale, and the losses can sink a bank that was sound the day before. Step through one below, then switch on deposit insurance and run it again.

Step throughA run on Harbour Savings

Day 0 of 2

Deposit insurance

Assets (book value)

Cash

Loans 95.0

Funding

Deposits 100

Equity

Cash

€15.0m

Loans

€95.0m

Deposits

€100.0m

Equity

€10.0m

Sound

Harbour Savings has €100m of deposits and €10m of equity. It holds €15m in cash and €95m of loans. If nobody runs, its €110m of assets repay every depositor with €10m to spare.

Deposit insurance works by changing what is sensible for each depositor. An insured saver will be repaid whatever happens, so queueing gains nothing. The central bank's lender-of-last-resort role (L1.2.08: Central banks) does the same job from the other side: the bank can borrow against its loans instead of selling them.

2. Externalities

When a bank fails, its shareholders lose, as at any company. But much of the cost falls on people who had no say: an externality. A bank does not count these costs when it decides how much risk to take, so left alone it takes too much.

Channel	Who else pays
Credit	Firms and households that relied on the bank lose their lending and must find it elsewhere
Payments	Customers cannot pay wages or bills while accounts are frozen
Fire sales	Every other holder of the same assets marks them down
Contagion	Creditors of the failed bank take losses; depositors at similar banks start to worry
Public purse	Governments may spend public money to stop the damage spreading

Together these make up systemic risk. They are why a bank's failure is treated as a public problem and a shop's is not.

3. Moral hazard

The cures for runs and externalities create a new problem. Insured depositors stop checking how their bank lends. Shareholders enjoy limited liability: if a gamble pays off they keep the gain; if it fails, losses beyond their equity fall on the deposit insurer. And a bank seen as too big to fail can borrow cheaply because lenders expect a rescue. Taking more risk because someone else carries the downside is moral hazard. The answer is to make the owners keep enough of their own money at stake, and to send in a supervisor to watch: capital rules and supervision are the price of the safety net.

Behind all three sits asymmetric information. A bank knows far more about its loans than its depositors do, and small savers cannot check. So a supervisor checks on their behalf.

What about insurers?

Insurers are paid first and pay later, sometimes decades later (L1.8.04: An insurer’s balance sheet). That makes them less prone to runs: most policyholders can only claim when an insured event happens. The main concern is policyholder protection. Customers cannot judge whether a promise due in 30 years will be kept, and an insurer is tempted to underprice and under-reserve, because the bill arrives long after the premium. Systemic trouble is rarer, but it happens when insurers move into bank-like business: in September 2008 the US authorities rescued AIG, whose losses came from derivatives and securities lending rather than ordinary insurance.

Sort itWhich market failure?

Pick the failure each story shows.

Savers queue at a bank because they fear others will empty it first.
A failing bank dumps its bonds, and the price fall hits every other bank that holds them.
A bank whose deposits are all insured doubles its lending to risky property developers.
Investors lend cheaply to a giant bank because they expect a government rescue if it fails.
A saver has no way of checking the quality of her bank's loans.
Small firms lose their credit lines when their local bank collapses.

The formal version

Moral hazard comes from one line of maths. With assets $A$ and debts $D$ , the owners receive what is left after the debts, but never less than zero:

\text{Owners' payoff} = \max(A - D,\ 0)

The floor at zero is limited liability. Whatever falls below it lands on the creditors, or on the deposit insurer if the debts are insured deposits:

\text{Insurer's loss} = \max(D - A,\ 0)

Because the owners keep every gain but only part of every loss, a gamble with the same or even a lower average outcome can raise their expected payoff. More equity (a smaller $D$ for the same $A$ ) moves the floor out of reach, so the owners bear the downside themselves.

Shown in full: it uses only subtraction and the larger of two numbers.

Try it

Start with thin equity and a 25% coin toss. Which plan do the owners choose? Now raise the equity until they switch.

Try itHeads I win, tails the insurer loses

Equity per €100m of assets€5.0m

Gamble: assets rise or fall by25%

The rest of the €100.0m is insured deposits. The safe plan grows assets by 2% for certain. The gamble is a coin toss, so on average it earns nothing: it is worse for the economy than the safe plan.

Owners: safe plan€7.0m

Owners: gamble, on average€15.0m

Insurer's expected loss€10.0m

Owners choose: the gamble

With a 25% swing, the owners prefer the gamble whenever equity is below €21m per €100m of assets. Above that, they have enough of their own money at stake to bear the downside themselves.

Worked example

One bank, two capital levels

A bank has €100m of assets. The safe plan grows them by 2%. The gamble moves them up or down by 25%, each with even odds. Deposits are insured and, to keep it simple, pay no interest.

Equity of €5m, then €25m

Step 1 of 5

1
Thin equity: the safe plan
Deposits are €95m. Assets grow to €102m, so the owners get 102 − 95 = €7m.

Back to the run: Harbour Savings had €110m of assets against €100m of deposits, yet on its first day it had to sell €25m of loans for €15m. Liquidity and solvency are linked: a run creates the losses it fears.

Regulatory lens

Each failure has its own answer, and the rest of this module meets them one by one.

Failure	Main answers	Where next
Runs	Deposit insurance, lender of last resort, liquidity rules (LCR, NSFR)	L2.7.04: Basel III and its finalisation
Externalities	Capital rules, extra buffers for large banks, resolution regimes	L2.7.02: The Basel Committee and Basel I to L2.7.04: Basel III and its finalisation
Moral hazard	Minimum capital, supervision, limits on deposit insurance	L2.7.03: Basel II: three pillars, L2.7.07: The EU, UK and US landscape
Policyholder protection	Solvency II and other insurance capital regimes	L2.7.05: Solvency I to Solvency II

Deposit insurance has limits so that large depositors still watch their bank: in the US the FDIC covers US$250,000 per depositor, per insured bank, for each ownership category, and EU schemes cover €100,000 per depositor per bank. Resolution regimes, agreed through the FSB, aim to let even a large bank fail with losses borne by its shareholders and creditors rather than taxpayers.

Sparks

SparkA Nobel Prize for a bank run model

In 1983 Douglas Diamond and Philip Dybvig showed that a bank run can happen to a perfectly sound bank, simply because each depositor fears the others will run, and that deposit insurance can remove the fear. In 2022 they shared the Nobel Memorial Prize in Economic Sciences with Ben Bernanke for research on banks and financial crises.

SparkThe fund that broke the buck

Money market funds aim to keep their shares worth exactly $1. On 16 September 2008, the day after Lehman Brothers failed, the Reserve Primary Fund announced its shares were worth less than $1 because it held Lehman debt. Investors pulled money from other funds too, and the US Treasury stepped in with a guarantee programme. One firm's failure had reached savers who never dealt with it: an externality in action.

Key takeaways

Regulation is justified where markets fail: private choices that make sense for each person leave everyone worse off.
Runs are self-fulfilling: fire sales to pay depositors can sink a sound bank. Deposit insurance and the lender of last resort remove the reason to run.
Bank failures hurt outsiders (borrowers, payments, other banks, taxpayers): externalities that the bank does not price.
Safety nets create moral hazard. Minimum capital keeps owners' own money at risk; supervisors watch on behalf of depositors who cannot.
Insurers are less prone to runs; their regulation focuses on keeping long-term promises to policyholders.

Reaction

Check what stuck

Glossary

Market failure: A situation where people acting sensibly for themselves produce an outcome that is worse for society.
Bank run: Many depositors or creditors withdrawing at once because they fear others will withdraw first.
Fire sale: Selling assets in a hurry, below what they would fetch with time to find buyers.
Externality: A cost (or benefit) of a decision that falls on people who had no say in it.
Systemic risk: The risk that trouble at one firm spreads and disrupts the financial system and the wider economy.
Moral hazard: Taking more risk because someone else will bear part of the cost if things go wrong.
Asymmetric information: When one side of a deal knows much more than the other, as a bank does about its own loans.
Deposit insurance: A guarantee, usually run by a public body, that repays depositors up to a limit if their bank fails.
Limited liability: Owners can lose what they put in, but no more: the company's debts are not theirs.
Too big to fail: Too big to fail: so large or connected that the government is expected to rescue it rather than let it fail.

Deep Dives & Origins

Deep Dives

Brunnermeier, Crockett, Goodhart, Persaud and Shin, The Fundamental Principles of Financial Regulation, Geneva Reports on the World Economy 11, ICMB and CEPR, 2009. Intermediate.
Dewatripont and Tirole, The Prudential Regulation of Banks, MIT Press, 1994. Advanced.

Origins

Diamond and Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy 91(3), 1983.
Board of Governors of the Federal Reserve System, Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April 2023.
The Royal Swedish Academy of Sciences, scientific background to the 2022 Prize in Economic Sciences, “Financial intermediation and the economy”.
Federal Deposit Insurance Corporation, deposit insurance coverage pages; Directive 2014/49/EU on deposit guarantee schemes.
Freixas and Rochet, Microeconomics of Banking, 2nd edition, MIT Press, 2008.

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