Because bank deposits in Cyprus, and virtually everywhere, are insured, the plan shocked many people who figured that this insurance was the one financial safety net that was still truly “safe.”

The Cypriot Parliament shot down the plan, though a smaller hit to depositors — many of whom are wealthy foreigners — was still in the offing late last week. Yet the tempest in the eastern Mediterranean is a reminder that depositors, in fact, are also creditors of banks and are potentially at risk.

In the United States, deposit insurance is viewed as sacrosanct. But even here, such plans haven’t always worked, and at least until recent times they have been contentious.

If the nation has a father of bank insurance, it is Joshua Forman, one of the promoters of the Erie Canal. Early in the 19th century, New York State had a string of bank failures, and Martin Van Buren, then governor, asked him to restructure the banking industry. Forman’s insight was that banks were vulnerable to chain-reaction panics. As he put it — in a line unearthed by the Harvard Business School historian David Moss — “banks constitute a system, being peculiarly sensitive to one another’s operations, and not a mere aggregate of free agents.”

In 1829, Forman proposed an insurance fund capitalized by mandatory contributions from the state’s banks. Debate in the State Assembly was heated. Critics said failures could overwhelm the fund; they also argued that its very existence would reduce the “public scrutiny and watchfulness” that restrained bankers from reckless lending. This remains the intellectual argument against insurance today. But Forman’s plan was enacted, and subsequently five other states adopted plans.

All did not go smoothly. In the 1840s, during a national depression, 11 banks in New York State failed and the insurance fund — as prophesied — was threatened with insolvency. The state sold bonds to bail it out.

After the Civil War and the establishment of nationally chartered banks, the state insurance systems were allowed to die. But banking panics and money shortages in the 1870s and ’80s revived the issue. Republicans thought the way to stop panics was to establish a central bank. Democrats were inveterate central-bank haters, but they needed a solution. William Jennings Bryan, the party’s three-time presidential nominee, called for deposit insurance, especially to protect small depositors.

Bryan lost the elections, but he won a victory of sorts on insurance. In 1907, a Wall Street panic led to a depression, and banks nationwide resorted to doling out scrip rather than cash. With the economy still in free-fall, Oklahoma adopted deposit insurance. Republicans were hotly opposed. President William Howard Taft, running against Bryan for president in 1908, said the Oklahoma law “put a premium on reckless banking.” The industry predicted that the system would fail. Depositors, argued James Laughlin, a banking expert of the day, should rely on the “skill, integrity and good management” of bankers.

Oklahomans thought otherwise. So great was the demand for insurance that Oklahoma banks with national charters liquidated and reorganized as state banks to participate. In fact, people in neighboring Kansas began to deposit in Oklahoma, forcing Kansas to enact a similar plan. Ultimately, eight states adopted insurance.

Their experience, alas, bore out the critics’ warnings. Depressed farm prices led to waves of bank failures in the 1920s, and one by one state systems folded.

Roger Lowenstein is writing a book on the origins of the Federal Reserve.

Article source: http://www.nytimes.com/2013/03/24/business/deposit-insurance-and-the-historical-reasons-for-it.html?partner=rss&emc=rss