The Well-Known Problems with Government Deposit Insurance

T he problems with federal deposit insurance have been known for years, even by the president who signed the bill that created the FDIC.

In a recent blog post, monetary historian George Selgin considers the history of the FDIC. First, Selgin writes that the deposit-insurance scheme that the FDIC uses was not new when it was first adopted. In fact, state governments had experimented with similar schemes in the 1800s. New York, Michigan, and Vermont all created FDIC-style deposit insurance; all three states’ schemes failed before the Civil War started.

Second, the FDIC’s creation was not necessary to help end the Great Depression, nor was it designed to do so. According to Selgin, proponents in Congress believed that the FDIC would help maintain the pre-crisis banking system of thousands of small, independent banks with no branches. Making it easier for banks to branch out would have helped them diversify their risks and made deposit insurance less necessary, but prominent lawmakers opposed branching for fear that banks would become too big.

Third, Franklin Roosevelt strongly opposed federal deposit insurance and only took credit for it after the bill was passed. Selgin writes:

FDR’s opposition to deposit insurance was sincere, earnest, and perfectly conventional. In October 1932, while campaigning for the presidency, he responded, privately, to a letter from a supporter urging him to publicly declare his support for federal deposit insurance as doing so would reassure the public while gaining him votes. Roosevelt demurred. Though it might be popular, he said, insurance was also “dangerous,” for in time it “would lead to laxity in bank management and carelessness on the part of both banker and depositor,” one result of which would be “an impossible drain on the Treasury.”

The same argument could be made today. Economics professor Bryan Cutsinger, writing for the American Institute of Economic Research, recently made the case for abolishing government deposit insurance. He noted that it creates moral hazard for banks’ corporate managers by encouraging them to make riskier decisions with depositors’ money, and depositors have little reason to care since their money is protected either way at no cost to them.

What changed Roosevelt’s mind, Selgin writes, was not a reevaluation of the economic soundness of the case against government deposit insurance, but rather an acquiescence to political reality. After the tide had turned against him, Roosevelt met with the lawmakers drafting the bill in a last-ditch effort to stop them from including the deposit-insurance program. They called his bluff and passed it anyway, after which Roosevelt signed it and took credit for the politically popular program.

Selgin notes how unusual the United States was for adopting government deposit insurance in the way that it did:

That uninsured banking systems could be stable explains the fact that, apart from the United States and Czechoslovakia, no other nation chose to guarantee its banks’ deposits until the 1960s, and only a score had done so as late as 1980. Furthermore, those that opted for insurance didn’t necessarily do so because their banking systems had proven unstable without it. Canada, for example, decided to establish its Canadian Deposit Insurance Corporation in 1967 even though no Canadian commercial bank had failed since 1923, and none was then in danger of failing.

Nor does the spread of deposit insurance since the 1960s appear to have occurred in response to policymakers’ perception that their banking systems were at risk of failing without it. Instead, many nations appear to have jumped on the deposit insurance bandwagon either because (mostly U.S.-trained) economists at the World Bank and the IMF pressured them to do so . . . or simply because doing so had become fashionable.

Cutsinger makes the point that government deposit insurance is unstable because it isn’t priced on an open market. For most of the FDIC’s history, every bank paid the same assessment rate. In 1993, the FDIC began charging risk-based premiums to some banks, a practice that Congress allowed it to expand to all institutions in 2006, but those premiums are still based on regulatory categorization and aren’t market prices. Cutsinger writes that without profit-and-loss signals, “political incentives, rather than market forces, will be the primary factor determining the price of deposit insurance.”

Arbitrary political decisions, rather than any reasoned economic approach, have altered the cap on deposit insurance as well. It was initially capped at $2,500; now it’s $250,000. In 1934, when the law took effect, $2,500 had the buying power of about $57,000 today, so coverage is far more expansive today, even accounting for inflation. The cap was set at $100,000 in 1980 and left alone until 2008, when it was raised to $250,000 temporarily, and then permanently, in the Dodd–Frank legislation.

The $250,000 cap might as well be universal deposit insurance for individuals, since hardly anyone has more than $250,000 in a bank account. (And if you are one of the few who do, there’s a relatively easy trick to ensure that all of your money is protected: Open multiple accounts and keep no more than $250,000 in each.) The reason deposit insurance was an issue in the recent Silicon Valley Bank collapse was that the bulk of SVB’s deposits were from corporations holding far more than $250,000 each.

The creation of the FDIC as it exists now was not the result of rational economic analysis, but of a hodgepodge of political decisions and arbitrary rulemaking. Selgin notes that government deposit insurance has contributed to instability and moral hazard in the banking systems of the U.S. and other countries. If policy-makers are thinking of expanding the FDIC even further in the wake of SVB’s collapse, they should think again.