The Flawed Explicit Safety Net: How Federally Sponsored Deposit Insurance Contributes to Financial Crisis

November 30, 2013

In the spring of 2012, JPMorgan Chase and Co. (JP Morgan), one of the largest and most profitable banks in the United States, made a $6 billion mistake. The issues all began in London, with a division of JP Morgan known as the Chief Investment Office (CIO). While the CIO’s stated purpose was to use excess deposits to hedge against interest rate risk, it had in fact been responsible for earning approximately $4 billion in profits for JP Morgan over the three previous years. This all came to a screeching halt when Bruno Iksil, now known as the “London Whale,” took a series of high–risk positions in derivatives and credit default swaps (CDS). To date the incident has cost JP Morgan billions of dollars in losses and fines and resulted in the criminal prosecution of several individuals involved in the incident.

Politicians and commentators have held the London Whale incident up as another example of large complex financial institutions behaving badly, and have accordingly pushed for stronger measures to eliminate the implicit subsidies that make such entities and their bad behavior possible. Lacking from this debate has been any meaningful discussion of the impact that explicit subsidies, like deposit insurance, have on the financial system in the United States. This is despite the fact that the funds the CIO used to make such fantastic profits for JP Morgan were federally sponsored deposits. This Note describes how the explicit federal safety net, specifically federally sponsored deposit insurance, contributes to the creation of financial instability and, potentially, financial crisis. This Note then analyzes several proposed reforms that could alleviate these problems, and, while continually advocating for increased attention to this issue, ultimately suggests a system of narrow depository institutions to solve it.

December 2013

No. 3