Federal Deposit Insurance for the 21st Century

Published September 24, 2008

A holdover from the 1930s-era New Deal programs, the Federal Deposit Insurance Corporation (FDIC) aims to limit the occurrence and mitigate the effects of bank closures. Critics of FDIC say the government-guaranteed deposit insurance and regulation system actually creates instability and risk in the banking industry.

Studies comparing free-market and regulated banking systems, including FDIC, have shown free-market banking systems to be significantly less prone to failures than regulated banking systems. The recent troubles of a growing number of FDIC-insured member banks suggests a reexamination of banking policy is needed.

The Deposit Insurance Fund (DIF) currently is holding $45 billion in reserve and covers roughly $4.5 trillion in deposits, for a reserve ratio of around 1 percent. Using the highest possible requirements imposed on member banks and DIF reserves, the high-end reserve ratio reaches only 11.19 percent of total deposits.

It is estimated that the recent Endemic seizure and bailout will cost DIF between $4 and $8 billion. Just this one instance of a bank failure will deplete 7 to 15 percent of the total fund [Chicago Tribune]. It is clear FDIC has inadequately assessed the risks associated with its member banks and DIF is insufficient to cover widespread losses.

If bank closures continue at recent rates or accelerate, FDIC may not be able to fully cover the deposits of its members. Federal Reserve and Treasury intervention might be required to meet the FDIC guarantee to depositors, costing taxpayers billions or even trillions of dollars over the long term.

Free-market scholars have long been critical of FDIC and the U.S. banking system. Seeing the flaws in the current system, they’ve recommend needed free-market reforms.

George Kaufman, professor of banking and finance at Loyola University Chicago, contends banking regulations have a strong negative effect on banking stability [Kaufman, Cato Institute] He notes:

  • Regulations constrain banks’ ability to diversify by limiting their portfolio choices.
  • Regulations also restrict branching, thereby restricting banks’ ability to react to market forces.

  • Mandatory federal deposit insurance acts as an implicit tax, reducing banks’ profitability by imposing fees and assessments.
  • FDIC creates a moral hazard by encouraging risk-taking by banks. The implied FDIC safety net hinders the due diligence of banks, investors, and depositors alike, creating a false sense of security in the financial stability of banks and causing parties to not adequately vet the risk of investments. [Economides et al., Cato Institute].

Privatization and deregulation are promising alternatives to federally subsidized deposit insurance. Jeffery Rogers Hummel of the Independent Institute recommends radical change in how deposit insurance is provided to depositors. Hummel recommends dissolution of FDIC and the Federal Savings and Loan Insurance Corporation (FSLIC) and the removal of all remaining regulations on depository institutions. Hummel believes the first step would “permit the competitive forces of the market to arrange actuarially sound insurance that protects depositors without subsidizing insolvency.” [Hummel, FEE] The second step would help depository institutions “gain the geographical and asset diversity necessary to shore up liquidity during runs.”

With the recent increase in bank failures, and more losses predicted in the future, it is clear steps need to be taken to improve the stability of American banks. A free-market privatization and deregulation plan to reform the banking system is an increasingly attractive alternative to the beleaguered FDIC system.

The FDIC recently decided to raise the premium it charges individual banks that participate in the federal deposit insurance program. Given the rising number of banks being seized by the FDIC, numbering 12 since the beginning of 2008, raising the premium is a step in the right direction. (U.S. FDIC plans significant bank premium increase)  

Despite the claims of FDIC regulators to the contrary, the adequacy of the Deposit Insurance Fund, now down $7 billion since the beginning of the year, must be questioned. Further bank seizures could place taxpayers at risk should the fund be depleted. It should be noted that the increase of the FDIC premium is not a long term solution, systematic changes are necessary to insure that taxpayers do not pay the price of bank mismanagement.

The following articles address some of these concerns and examine the Federal Deposit Insurance Corporation from a free-market perspective.

Is Free Banking More Prone to Bank Failures than Regulated Banking?
Kam Hon Chu, an assistant professor of economics at the Memorial University of Newfoundland, examines the commonly held claim that bank failures are more likely in free banking than in regulated banking. He found government regulation is not necessarily more effective than self regulation.

FDIC Reform: Don’t Put Taxpayers Back at Risk
George Kaufman, professor of banking and finance at Loyola University Chicago, comments on how taxpayers are put at risk by failing banks covered under the Federal Deposit Insurance Corporation (FDIC). Kaufman also examines some of the various reform proposals brought up in recent years.

In Defense of Bank Failures
This article, written by H.A. Scott Trask of the Mises Institute, comments on the negative effects federal deposit insurance can have on the economy. The article highlights FDIC’s role in encouraging bad banking, risky speculation, and permanent inflation. The author argues the FDIC de-emphasizes personal responsibility and shifts risk from banks to taxpayers.

Trading Bank Runs for a Systemic Bank Failure
This article, written by economic commentator Gary North, comments on the fallacy of using government to insure and regulate uncertainty in the market. “Government officials believe that by using coercion to contain the politically negative effects of uncertainty — systemic losses and even breakdown — they thereby reduce uncertainty.” North argues the gravest threat to the economy is not bank failures but a failure of the interbank payment system.

Federal Deposit Insurance: Economic Efficiency or Politics?
This article, written by the Nicholas Economides, R. Glenn Hubbard, and Darius Palia for the Cato Institute, examines the development of and rationale for FDIC. The authors contend FDIC and restrictions on branch banking were created to help bolster small unit banks at the expense of larger, better-capitalized banks.

Taking Money Back: Deposit Insurance
This essay on monetary policy, written by Murray Rothbard, considered by some to be the dean of the Austrian school of economics, includes a discussion of deposit insurance. Rothbard argues that deposit insurance is a swindle, creating a false sense of faith in the solvency of banks. Due to fractional reserve requirements, he notes, few banks hold enough money in reserve to cover their deposits. In the event of multiple runs on the bank, the Federal Reserve would be required to print additional currency to cover those runs, leading to hyperinflation.

Bank Failures, Systemic Risk, and Bank Regulation
George Kaufman of Loyola University Chicago explains how banking regulations, including FDIC, “have frequently been incentive incompatible and counterproductive and have unintentionally introduced both moral hazard behavior by the banks and principal-agent problems by the regulators that have intensified the risk and costs of banking breakdowns.” Kaufman also contends a lack of anti-systemic risk legislation does not necessarily increase the number of bank failures.

Too Big to Bail
Alex Epstein of the Providence Journal and Ayn Rand Institute examines the U.S. government’s “too big to fail” policy, which has led to multiple bailouts of large financial corporations since passage of the Federal Deposit Insurance Act of 1950. Epstein says any policy “that encourages overly risky investing and punishes sound risk-taking is unfair and destructive.” He promotes a free-market banking system, which would “reward sound long-term lending and borrowing practices and punish irresponsible ones.”

Privatize Deposit Insurance
Jeffery Rogers Hummel of the Independent Institute discusses in the Freeman an alternative to FDIC, deposit insurance privatization. Hummel says privatization could provide many of the stabilizing mechanisms of FDIC through the free-market process without using government subsidies.

Nothing in this document is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit The Heartland Institute’s Web site at http://heartland.org and PolicyBot, Heartland’s free online research database.

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