Regardless of the lack of sophistication of the average depositor or even most depositors, market discipline will work for bank deposits just as it does in other markets for financial assets where the average investor is no more sophisticated than the average depositor. Both Pete Allen and Bill Seidman are responding to the type of proposal that appeared in the Minneapolis Fed's 1988 Annual Report. In that essay John Boyd, senior research officer, and I recommended that bank deposits be coinsured, so that depositors share some of the risk of a bank failure. We also recommended that any such proposal be adopted gradually. The rationale behind coinsurance is to bring some market discipline to bear on depository institutions' behavior toward risk.
Most insurance has a potentially costly side effect.
In either case depository institutions will have less incentive to take on excessive risk. Pete Allen and Bill Seidman are worried that the market will not work as we suggest because most depositors are not sophisticated about banking and know little about their bank's portfolio. While they may be correct about the sophistication and knowledge of most depositors, they are wrong in concluding that this will somehow prevent the market from properly pricing bank risk and reducing the incentives insured institutions have toward risk. Depositors' ability or willingness to monitor banks should not be judged by their current behavior. Given that bank deposits today are almost fully insured, it is not surprising that few depositors know or care about their banks' portfolios.