Government sponsored insurance of bank deposits is nonsense.

When deciding where to place or invest one’s money, there are a variety of options ranging from the near 100% safe to the risky. Investing in short term government debt is a near 100% safe option (which can be done in the UK by depositing money in an account at National Savings and Investments).

In contrast, depositing money in a commercial bank is slightly more risky, and to reflect that risk, depositors demand more interest. But the additional interest they demand simply reflects the additional risk: no more and no less.

Now what should government charge if it wants to insure those commercial bank deposits? Well assuming government gauges the risk correctly, it will have to charge an amount that reflects the risk – no more and no less.

So, lo and behold, and assuming everyone gauges the risks correctly, the premium that government charges will cancel out the extra interest!!!  It’s all nonsense. It’s senseless paper shuffling exercise.

And in fact there are numerous individuals and organisations round the world who advocate a banking system under which those who want to try benefiting from extra risk carry that risk themselves. They’re right. Those advocating such a system include most advocates of full reserve banking and the following (some of whom advocate full reserve and some of whom don’t).

Laurence Kotlikoff, Matthew Klein, John Cochrane and this lot. 

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P.S. (23rd Aug. 2013): More on the above subject by yours truely here.