[mathattack]

In theory that's the central bank's job. 2 issues, though...

1 - It can be hard to tell the difference between solvency and liquidity. What's a derivative of an MBS really worth? Or a CDO that's made off of other CDOs that are trading at an undetermined liquidity discount? Or a unique plot of real estate?

2 - The bailout decisions are often political, as well as based on imperfect reads of fundamentals.

Yes, the FDIC provides run protection from both bad banks and good. Protecting bad is the price of protecting the good.

[nhaehnle]

1 & 2 basically elaborates on what I said ;)

And no, FDIC protection intentionally protects deposits at bad banks. This is not an accident. Trying to put the burden of evaluating what a bad bank is onto regular people is not going to end well, so you guarantee deposits at all banks, full stop.

Besides: Deposit insurance for deposits at good banks is pretty pointless, don't you think? It would never be used by definition.

[mathattack]

I think we agree on 99%.

My point is just that a good bank can still have a run in the absence of the FDIC guarantee.

Let's say a bank has $100 million in deposits. They keep $10 million in liquid assets, and lend out $90 million in un-securitized loans to local businesses. There's a false market rumor of something bad happening at the bank, and all of a sudden $20 million in depositors want their money back. The bank isn't able to resell the loans quick enough on the secondary market to make up for the shortfall. This could happen.

The FDIC guarantee protects the bank because there's no longer a need to have the run - everyone will get paid.

[nhaehnle]

I think you're right about our mostly-agreement :)

Just to clarify, I think we have to distinguish between the likeliness of a bank run and the effects of a bank run.

Indeed, the FDIC makes a bank run extremely unlikely. Perhaps this is what you mean by "protecting the bank".

However, even if there were no FDIC, a bank run on a good (solvent) bank would not cause that bank to collapse, due to the central bank's lender of last resort function.

The bank run would "merely" cause a shrinking of the bank's balance sheet, which the bank would have to offset by selling its assets over time.

It is true that a big change in the balance sheet like that could still lead to the eventual death of the bank, e.g. because the bank has high fixed costs (in the form of physical branches, non-fireable employees, and so on) which can no longer be covered by profits from its regular business. However, this eventual death is (a) not certain since the bank has plenty of opportunity to turn things around and (b) a slow death, very much unlike the sudden implosions that people usually think of when they hear "bank run".

[mathattack]

Once a run happens, the central bank has to make a choice on who to lend to based on imperfect information, though. The central bank might say, "I don't know about all these local real estate loans, let's let them fail."

It's the FDIC that removes this possibility.

Thanks for engaging in this conversation!