More fundamentally, in my view, funding market disruptions reflect a striking decline in confidence in the financial architecture itself. Perhaps an analogue to banking systems without deposit insurance is appropriate: Depositors withdraw funds if they believe others will act similarly. In short-term credit markets with minimal liquidity support, investors balk if they lose confidence in other investors' willingness to roll maturing paper. Even when liquidity support exists, it may well prove insufficient to address market-wide concerns. ... After all, a loss in confidence can be completely rational: Illiquidity forces issuers to sell assets into distressed markets.

[T]he Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, took major steps toward reducing moral hazard in the banking system and limiting taxpayer losses by reinforcing the importance of strong capital.  Among the mechanisms in the act is the requirement that bank supervisors take prompt corrective action when depositories show signs of becoming troubled.  This step was reinforced by the least-cost requirements of FDICIA, which generally require the FDIC to resolve a failing institution in the manner least costly to the deposit insurance fund.

The safety net reduces the incentives of private financial counterparties to manage the exposures they take on. And these incentive effects arise not just from such explicit safety net guarantees as deposit insurance. They may also result from the expectations of private market participants about actions that the central bank or other public sector entity might take during a financial crisis. The mere possibility of public sector action to stem so-called "systemic" losses, such as central bank lending, can provide an implicit safety net that makes some participants more willing to hold concentrated exposures. Hence, under this moral hazard view of the need for regulation, the safety net itself can be a source of "systemic" risk.

Market discipline, however, may not always be fully effective in this context. The development of the federal safety net--deposit insurance, the discount window, and access to Fedwire and daylight overdrafts--has inevitably impeded the workings of market discipline in the regulatory arena. That is, the various elements of the safety net provide depository institutions and financial market participants with a level of safety, liquidity, and solvency that was far less prevalent before the advent of the Federal Reserve and the subsequent establishment of federal deposit insurance. By deterring liquidity panics, the safety net shields the overall economy from some of the worst effects of instability in the financial system. These benefits, however, are not without costs. The prospect of government intervention distorts market prices and may also engender excessive risk-taking.

I've consistently argued that increases in deposit insurance coverage are unwise...

I also have concerns that deposit insurance reform didn't go far enough in reforming the pricing of deposit insurance. Now, this is a tricky topic, with much detail to it, but the crux of the issue is straightforward. I think the Federal Deposit Insurance Corp. should charge premiums based on the riskiness of banks.

Gramm-Leach-Bliley reaffirmed as a matter of public policy that banks continue to be regarded as special. But the act offers a clear acknowledgment that the separation of banking and commerce is not a bright line but is instead a negotiated compromise--one that will continue to move as markets change and products are refined. The guiding consideration in this compromise will be the protection of the federal deposit insurance fund.

The FDIC does not have the authority to supervise the corporate owners of ILCs and their affiliates in the same manner that bank holding companies and their nonbank affiliates are supervised under the BHC Act. The GAO recently concluded that, due to these differences in authority, exempt ILCs may pose more risk to the deposit insurance funds than banks operating in a bank holding company structure.

The relation of central bank credit to the broader public safety net has implications that are sometimes overlooked. For example, the collateralization of central bank credit extension may reduce risks to the central bank, but it can increase risk to the deposit insurance fund. Therefore, the central bank ought to consider more than just its own balance sheet risk in making lending decisions. This is especially important because, as the lender of last resort, the central bank can often force an institution’s closure by refusing credit.