Without a safety net, banking is unstable. This proposition finds support in economic theory. In an influential analysis, Douglas Diamond and Philip H. Dybvig showed that banks without deposit insurance exhibit multiple equilibria—one of which is a bank run. [1] And financial history confirms this hypothesis. Banking panics were common in the U.S. before the enactment of deposit insurance, but nonexistent thereafter.

The apparent instability of banking has given rise to a standard policy response in the form of a social contract (a phrase borrowed from a marvelous speech by Paul Tucker of the Bank of England). [2] That contract entails certain privileges that are unavailable to other firms: most notably, access to central bank liquidity and federal deposit insurance. These privileges amount to a safety net, and they stabilize banking. The social contract also imposes obligations—activity restrictions, prudential supervision, capital requirements, and deposit insurance fees. These obligations are designed to counteract the moral hazard incentives implicit in the safety net and protect taxpayers from losses.

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