Being rescued by the FDIC is likely to be a disaster for a bank’s shareholders and its executives.
Far from preventing a potential crisis, it may actually make a crisis more likely by worsening the moral hazard.
A n ounce of prevention is worth a pound of cure. But what happens when the supposed prevention is the cause of the disease?
Since the collapse of both Silicon Valley Bank and Signature Bank in 2023, regulators at the Federal Deposit Insurance Corporation (FDIC) and elected officials have put forward various proposals to increase federal protections for deposit insurance in the hopes of preventing a future banking crisis. There are several bills being considered by Congress right now that would raise the FDIC limit beyond the current limit of $250,000 per account-holder per institution. The idea is that, if depositors know that their money is safe in the event that their bank fails, they’ll be less likely to hurriedly withdraw their money and trigger a bank run.
But increasing deposit insurance, far from preventing a potential crisis, may actually make a crisis more likely by worsening the moral hazard. In economics, moral hazard “refers to the risks that someone or something becomes more inclined to take because they have reason to believe that an insurer will cover the costs of any damages.” Essentially, account holders in search of higher yields will be more willing to park their money at riskier banks than they otherwise would be by operating on the assumption that the FDIC will cover losses if the bank fails. Similarly, banks are flush with funds they wouldn’t otherwise have in the absence of higher deposit insurance, and they are incentivized to take more risks.
The idea that insurance can increase risk is less counterintuitive than it seems. Insurance essentially transfers the risk of loss, but it does not eliminate it. In fact, it may increase the risk of loss, even if someone else bears it, by reducing the incentive of the insured party to take care to avoid that loss.
This, however, is less straightforward when it comes to FDIC insurance. Being rescued by the FDIC is likely to be a disaster for a bank’s shareholders and its executives. It will also be of relatively limited comfort to those with deposits in excess of the FDIC maximum.
Even so, in a 2010 report, the U.S. Government Accountability Office warned that increasing deposit insurance “could weaken incentives for newly protected, larger depositors to monitor their banks, and in turn banks may be more able to engage in riskier activities.” And of course, banks that engage in riskier activities are more likely to fail.
Since a bank’s financial security is less important to potential customers with federally insured deposits, banks likewise have less incentive to keep high safety and soundness standards. Knowing that their depositors are unlikely to pull their funds out, some banks are tempted to make riskier, higher-return loans and investments (particularly if they have been successful in attracting additional funds).
Repeated enough on a large scale, this behavior can destabilize the banking sector. As a 2016 study conducted by researchers at the World Bank and the International Monetary Fund concluded, “deposit insurance may lead to more bank failures and, if banks take on risks that are correlated, systemic banking crises may become more frequent.”
The problem isn’t merely theoretical. In 2016, a group of researchers analyzed real-world data from 118 countries over the course of 24 years and found that when governments offer deposit insurance to private banks, there is a “positive and significant effect on bank insolvency and bank runs.”
The FDIC itself recognizes the inadequacy of deposit insurance. In a 2023 report on insurance reform, the agency concluded that, even if the deposit-insurance maximum had been ten times as much as it is now, a run still would have occurred at Silicon Valley Bank and it still would have collapsed. Many policy-makers now believe that, if the FDIC is to prevent bank runs, the deposit-insurance maximum needs to be essentially unlimited. Just last year, Democrat Representative Adam Schiff introduced a bill that would allow the FDIC to unilaterally increase the deposit-insurance maximum and potentially make it unlimited. Not to be outdone, Republican Senator J.D. Vance proposed a bill that would have allowed banks with assets of less than $225 billion to have unlimited deposit insurance. Vance’s bill would not even have charged these banks additional fees for the extra insurance.
But unlimited deposit insurance would only exacerbate the problem of moral hazard. If the banking industry can be destabilized with a deposit-insurance limit of $250,000 (and the research says that it has been), one can only surmise how much more unstable it would be with no insurance limit at all.
The high-profile collapse of banks last year brought up many bad memories of the 2008 financial crisis, and politicians are feeling pressured to prevent a similar calamity. At a time when new mortgage production is low, commercial real estate values have fallen precipitously since 2022, and loan delinquencies are rising, the wrong federal policy could have dire consequences. If the government increases deposit insurance, banks could see this as permission to play recklessly with their depositors’ money, putting the industry in an even more precarious position than it is right now.
Policy-makers should avoid passing reforms that only give the illusion of financial stability, lest they trigger the very crisis they are trying to prevent.