A Government-Guaranteed Deposit System Artificially Lowers the Cost of Debt Financing for Banks and Increases the Proportion of Debt in the Balance Sheet of the Banking System

Central banking’s provision of deposit insurance with artificial ceilings on interest rates paid on those deposits also diminishes capital adequacy in the banking system. Finance theory demonstrates that firms (banks included) will choose a proportion of debt and equity in their capital structure that minimizes the blended cost of capital. But a government-guaranteed deposit system that is backed by a central banking institution with a monopoly on fiat base money creation, lender-of-last-resort powers, and the right to limit deposit rates, artificially lowers the cost of debt financing for banks and increases the proportion of debt (and lowers the proportion of capital) in the balance sheet of the banking system. Banking is the only industry in which the government agrees to guarantee the short-term liabilities of every participant. It is an arrangement that naturally encourages the use of debt (deposits) instead of capital to finance asset growth. There is a substitution of “public capital” (government-insured deposits) for “private capital” (equity that would have been employed in the absence of government-guaranteed deposits). The imposition of corporate taxation and the tax-deductibility of interest expense (but not dividends) also reflects government intervention and further promotes leveraging and capital inadequacy in the banking industry. Although the banking industry shares with other industries this tax-driven motivation to employ more debt than capital, corporate taxation and tax-deductible interest nonetheless remain nonmarket factors bearing on the decision to leverage. They would not be operative in a free market.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 30.