Government Deposit Insurance
Although the economy suffered greatly from the stock market crash of 1929, bank failures did not escalate until 1930, then continually increased over the next few years, primarily because the Federal Reserve contracted the money supply in an attempt to maintain the gold standard, and because the United States government instituted new taxes, especially the Smoot-Hawley tariff, to balance the budget, which reduced the amount of money held by the public. Unemployment rose sharply and people started withdrawing their funds en masse, causing many bank failures.
Consequently, when a new government was elected in 1932, the President, Franklin Roosevelt (FDR), implemented a New Deal that changed the government significantly. Included in these changes was the Banking Act of 1933, which created a new agency, the Federal Deposit Insurance Corporation (FDIC), to insure bank deposits so that bank runs by depositors would end, and it was largely successful.
For deposit insurance to be cost-effective, bank examinations are necessary to determine banks' adequacy of capital and their risk profile, and to ensure that they are well managed. The initial bank examination reduces adverse selection where banks in poor financial shape actively seek insurance to protect their depositors and their business. Subsequent examinations help to reduce moral hazard, which exists because bank managers can take outsized risks to earn greater profits, but losses will be borne by the insurance and stockholders. Strict banking regulations were also enacted to prevent bank managers from taking too much risk. Indeed, for most of the 20th century, banking regulations, especially interest rate caps on deposits and restrictions on branching, were designed to reduce competition to reduce both moral hazard and bank failures.
Deposit Insurance Prevents Bank Runs
Banks make profits by lending out the money deposited by the bank's customers. Hence, banks keep only a small amount of money at their premises, so if too many people try to withdraw their money at the same time, it could cause banks to fail even if they were financially sound.
Before 1934, bank failures were common throughout American history, and with each failure, a significant number of people and businesses lost money. Since banks had a first-come, first serve policy, people rushed to the bank as quickly as possible to try to withdraw their funds. Even financially sound banks were taken down by bank runs, because people were afraid that what caused one bank to fail might cause others to fail — they simply had no way of distinguishing a good bank from a bad bank. Lost money and bank failures also contracted the money supply, which caused deflation and unemployment.
Deposit insurance effectively prevents bank runs, which also prevents bank failures due to runs on the banks. However, deposit insurance does not prevent bank failures due to mismanagement or because the bank managers took excessive risks.
Federal Deposit Insurance Corporation (FDIC)
The FDIC collects premiums from member banks to fund an account, the Deposit Insurance Fund (DIF), which covers depositors for any losses resulting from bank failure. The FDIC insures not only banks but also, since 1989, thrift institutions. Credit unions are insured by the National Credit Union Administration (NCUA).
Before the FDIC insures a bank, it determines whether it is financially sound by the amount of bank capital, the quality and experience of its managers, and the bank's future prospects. Before 1991, the FDIC charged the same premium, which averaged about 8¢ for every $100 of deposits, for all banks. With the enactment of Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991, the FDIC started charging risk-based assessments in 1993 based on a 9-group category, where each group is distinguished by the amount of its bank capital (1-3) and by its supervisory grade (A-C) it receives from the FDIC's annual examination. A bank in group 1A pays the lowest premium while a 3C bank pays the highest.
FDIC insurance covers funds in deposit accounts, including checking and savings accounts, money market deposit accounts and certificates of deposit. FDIC insurance does not cover other financial products that insured banks may offer, such as stocks, bonds, mutual fund shares, life insurance policies, annuities or municipal securities.
On May 20, 2009, President Obama signed the Helping Families Save Their Homes Act, which increases the amount covered from $100,000 to $250,000 per depositor through December 31, 2013. The FDIC currently insures each depositor at each bank for up to $250,000. If a depositor has accounts at separate banks, then each account, up to the limit, is covered. It is possible to qualify for more than $250,000 in FDIC coverage at the same insured institution if you have deposit accounts in different ownership categories such as single accounts, joint accounts, Individual Retirement Accounts (IRAs) and trust accounts. Additionally, corporation and partnership account deposits at the same institution are insured up to $250,000 and are insured separately from the personal accounts of the entity's stockholders, partners, or members.
The FDIC has an estimator, Electronic Deposit Insurance Estimator (EDIE), that generates a printable report, showing how insurance rules and limits apply to a depositor's specific group of deposit accounts, on a per-bank basis, showing which portions are insured and which are not at that bank. EDIE can show the insurance coverage for:
- personal accounts, including single accounts, joint accounts, POD/ITF accounts, living trust accounts, and Individual Retirement Accounts (IRAs)
- business accounts, including accounts held by corporations, partnerships, and organizations, whether for-profit and not-for-profit
- state and local government accounts
The FDIC does attempt to protect large depositors because most of these are held by businesses and their loss may cause their failure, with negative repercussions for the local economy, and it may cause bank runs by large depositors on other banks, which may precipitate their failure. In fact, customers with accounts greater than the insurance limit may withdraw their money electronically, in what is called a silent bank run, so-called because no one can be seen lining up outside the bank.
Although it would not be much more expensive to insure all amounts held by a bank, the FDIC sets limits so that the bank will refrain from taking large risks so that they can attract business customers with large accounts.
When a bank failure does occur, the FDIC can use a number of methods to satisfy its mandate, but, by law, it must choose the least expensive method. Often, it will try to merge the failing bank with a stronger bank, in what is called the purchase-and-assumption method (aka deposit assumption method), where it finds a buyer for the bank. This not only relieves the FDIC of paying depositors, but the bank stays open under new management with the least disruption to the local economy. It also protects large depositors. To facilitate a merger, the FDIC buys the bad assets of the failing bank to make it more attractive for the acquiring bank.
If the FDIC cannot merge the bank with another, it will then have to pay depositors for their losses, using the payoff method, where the FDIC pays depositors up to a maximum amount. If the customer has a loan with the bank, then the FDIC calculates the customer's payment by subtracting the amount of the loan from the deposit.
The FDIC manages the receivership of failed banks and reimburses itself by selling the bank's assets and collecting on its loans.
Infrequently, the FDIC may make a loan to the bank to prevent its failure, or it may reorganize it. Open-bank assistance is sometimes provided to keep banks open in communities that the FDIC deems was providing essential services to the community. For instance, in the early 1980's the Bank of the Commonwealth received open-bank assistance because it was providing banking services to minorities in Detroit.
Advantages and Disadvantages of Deposit Insurance
The advantage of deposit insurance is clear: it did stop bank runs with the resulting bank failures, and gave people a greater confidence in the financial system. In 1934, the 1st full year that deposit insurance was in force nationwide, only 9 banks failed compared to the 9,000 that failed in the preceding 4 years.
However, many people also think that deposit insurance has its disadvantages. Many have argued that since so few banks have failed over the years, especially in the 1950's and 60's that deposit insurance is propping up mismanaged and uncompetitive banks. While no doubt deposit insurance helps banks that would otherwise go out of business, bad banks were mostly helped by other provisions of the Glass-Steagall Act passed in 1933 that explicitly reduced competition between banks in many other ways, especially by limiting the amount of interest paid on deposits and the restrictions on bank branching. A number of new laws have increased competition between banks, especially in 1980, when the Depository Institutions Deregulation and Monetary Control Act of 1980 was passed, and in 1999, when the Financial Services Modernization Act of 1999 was passed. Since then, bank failures have greatly increased even though deposit insurance is still in effect.
Another disadvantage often argued is that deposit insurance causes moral hazard that motivates bank managers to take bigger risks because their depositors are insured. But banks always had moral hazard because they earned profits using other people's money — whether it was the depositors', money that banks borrowed, or stockholders' money. For instance, many bank managers in the 1800's took large risks even when their banks were not covered by deposit insurance because it was not their money at stake, but they would reap the profits, and, naturally, many of them failed.
Another big cause of moral hazard in banking besides using other people's money is the too-big-to-fail policy. The Great Recession is a good example in which governments around the world were forced to bail out their banks with trillions of dollars to prevent them from collapsing because they made bad loans and bought or insured bad assets based on those loans. Bank managers took outsized risks to make big profits because they considered themselves too big to fail — in other words, if their failure were imminent, the government would be forced to bail them out. Of course, they were right, because that is what happened.
Unfortunately, the too-big-to-fail policy is probably necessary, since the failure of large banks with their interconnections would cause a contraction of the money supply, devastating the economy. Hence, governments will almost always be forced to bail out large banks when necessary. The solution to this problem is strict regulations and bank supervision.
Bank Supervision as an Alternative to Deposit Insurance
Bank failures in the 1800's were much more common, especially before the National Banking Act of 1863. Most banks then were state banks that issued banknotes, which were the currency of the day, that were supposed to be backed by gold or silver coins, or by state government bonds. However, there were many banks that were printing banknotes without any backing. A bank had to be able to exchange gold or silver coins for their banknotes whenever a customer demanded it, for if bank failed to do this even once, the customer would tell others, causing a run on the bank and its failure. Not only would the depositors lose their saved money, but also the holders of the banknotes, which became worthless.
Another major cause of failure was that unscrupulous people could start a bank and states didn't do much to enforce what few regulations there were at that time. State charters were required to start a bank, and, before the free banking era, could only be obtained from the state legislature, who often granted charters based on political favors rather than banking expertise. The free banking era began in 1837 when states started granting charters to anyone who satisfied minimal requirements, which only increased bank failures.
Some states tried to reduce bank runs by implementing deposit insurance as early as 1829, but Indiana used a different method of protecting depositors and banknote holders that was more successful. The state set up a mutual guaranty program which required all state banks to pay for any bank failures. A strong supervisory board was the cornerstone of the program.
A mutual guaranty program is like deposit insurance, but instead of banks paying a fixed amount into a fund, which is the way it is done today, the banks were directly liable for failures. Hence, banks could lower their own cost by making sure that every bank was managed wisely and avoiding unnecessary risk.
Under the mutual guaranty program, supervisory officials were largely selected by, and accountable to, the participating banks. The officials were given wide latitude to check unsound banking practices because the participating banks were keenly aware that the cost of lax supervision ultimately would be borne by them. The board had the power to close any member bank because of insolvency, mismanagement, or refusal to comply with any legal directive of the board. The board's power was absolute since there was no provision for appeal to the courts or to any other state agency.
During the Indiana program's 30 years of operation, not one state-chartered bank failed. Indiana's success principally was attributable to the quality of its bank supervision.
Deposit insurance has been an astounding success. Its most important achievement is that it gives people confidence in their banking system, and, thus, prevents economic downturns caused or exacerbated by the fear of depositors losing their money.