Another route would be to seek to address banks’ perverse incentives via idiosyncratic, riskbased capital requirements; ie active use of Pillar II of the Capital Accord, which is desirable in any case. One can argue that the two routes could be equivalent for the banking system as a whole. In a system of risk-based premia, the ex ante levies on “safe and sound” banks would obviously be lower than those on their riskier peers. In a system of variable capital requirements, the burden on the FSCS and so the ex post levies on the surviving “safe and sound” banks should crystallise less frequently, and perhaps also be smaller, the greater the amount of capital a riskier, failed bank had to carry. But it is not so straightforward. Unlike the US, the UK does not have a regime of “depositor preference”, which means that the FSCS ranks alongside (rather than ahead of) ordinary wholesale creditors and so shares losses with them. The risk-reducing benefits of extra risk-based capital would, therefore, be spread over  3  The FSA Consultation Paper, “Financial Services Compensation Scheme: Review of limits” (CP08/15), estimated that (based on BBA data for two large banks) the share of accounts covered by the increase in deposit insurance from £ to £ would rise from 96% to 98%, while the share of the overall value of deposits insured would rise from 52% to 60%.
It is no longer really about protecting depositors, as the vast majority are wholly protected by the insurance scheme. From a micro perspective, it is essentially about minimising risks to, and losses at, the deposit insurer, the UK Financial Services Compensation Scheme. Second, it also potentially alters the dynamics of the market place. It makes it easier for banks to pay up for deposits; the signal that a bank will take greater risk than otherwise, as it would have to, does not matter to the depositors. They are covered, and so simply enjoy the higher returns on their deposits. If the bank succeeds, the rewards are reaped by shareholders and management; if it fails, retail creditors get repaid in full. This doesn’t feel like a stable regime. And it is worth remembering that President Roosevelt seriously hesitated before introducing the equivalent FDIC scheme in the US in the 1930s for precisely that reason. One way of addressing these risks – and the approach eventually being tried in the US – would be to make such risk-taking banks pay a higher levy into the insurance scheme. Riskbased premia would help to offset the incentives otherwise created. And, of course, any such insurance scheme must be pre-funded; it is no good trying to collect levies from riskier banks after they have gone bust. That is why the Bank has advocated this course.