Deposit insurance reform: Is it deja vu all over again?

Federal Reserve Bank of St. Louis - Regional Economist, Oct 2002 by Vaughan, Mark D, Wheelock, David C

Deposit insurance reform is on Congress' agenda. The House of Representatives passed a bill in May, and the Senate is likely to debate reform this fall. Although the pending reform bill would change federal deposit insurance in many ways, none of its features has sparked more controversy than a proposal to raise the coverage ceiling, currently set at $100,000 per account, to $130,000 per account. On the one hand, the case for raising the ceiling seems simple: Inflation has eroded the real value of coverage considerably since the last increase, in 1980. On the other hand, bank failures dramatically rose and the thrift industry nearly collapsed in the wake of that increase. Was the spike in failures a coincidence, or did the higher deposit insurance ceiling have something to do with it? The 20th century U.S. experience suggests that boosting the coverage ceiling may not be such a good ideal1

Why Insure Deposits?

The economic argument for deposit insurance stems from the macroeconomic fallout from banking panics. In the past, depositors often had difficulty distinguishing financially sound from financially shaky banks. News about a regional economic shock would make depositors nervous because they could not determine the actual condition of their bank. Depositor nervousness grew out of the potential loss of uninsured funds should their bank fail. Before federal insurance, bad economic news would sometimes spook depositors into withdrawing funds from all banks. The U.S. banking system was uniquely prone to mass withdrawals or "runs" because the typical bank was small and its loan portfolio was undiversified. Severe episodes of runs-- banking panics-intensified economic downturns by disrupting the payments system and cutting the flow of credit to business firms. Indeed, some economists have attributed the depth and length of the Great Depression to the severe banking panics of the early 1930s.2

Deposit insurance is an antidote to banking panics. When their funds are insured, depositors will not view bad economic news with alarm. And the absence of alarm means the absence of panics.

Following the Panic of 1907, eight states established insurance systems. Then, in response to the panics of the early 1930s, when 9,000 banks-some 30 percent of the nation's total-went under, Congress established the Federal Deposit Insurance Corp. (FDIC). The FDIC offered coverage to all U.S. commercial banks. In 1933, a temporary ceiling on coverage was set at $2,500; in 1935, a permanent ceiling was fixed at $5,000. In 1950, the ceiling was raised to $10,000; in 1966 to $15,000; in 1969 to $20,000; in 1974 to $40,000; and finally in 1980 to $100,000. Federal deposit insurance succeeded in stabilizing the banking system; since the 1930s the United States has experienced no banking panics and, until the 1980s, almost no failures of insured institutions.3

So. What's the Problem with Deposit Insurance?

Although deposit insurance eliminated banking panics, it sometimes encouraged imprudent risk-taking. Deposit insurance encouraged bank risk-taking because the price of coverage-premiums and deductibleswas not set by the principles that guide private insurance companies.

Private insurance companies reduce their risk exposure with premiums and deductibles. In an automobile collision policy, for example, the insurer sets premiums based on expected payouts, which in turn reflect the chance an insured driver will crash and the cost of repairing his car if he crashes. To deter insured parties from driving recklessly because they are covered-a phenomenon that economists call moral hazard-private companies charge higher rates to accident-prone drivers and insist on deductibles from all drivers. Deductibles encourage safe driving-that is, they combat moral hazard-because insured parties must bear some of the cost of accidents. Insurers also control risk exposures by pre-screening applicants. Pre-screening prevents reckless drivers from disproportionately obtaining coverage-- a phenomenon that economists term adverse selection. Deductibles reduce adverse selection as well as moral hazard because reckless drivers will steer clear of policies that force them to share the cost of crashes.

Unlike private insurance, deposit insurance plans typically have not linked premiums to expected payouts. Instead, public plans have used flat premiums-that is, rates set as a fixed percentage of deposits-because they are simple to administer. Marginal analysis-a staple in the economist's tool kit-can demonstrate the resulting incentive problems. Bankers take on risk up to the point where the extra, or marginal, benefit of risk-taking equals the marginal cost. The marginal benefit of risk-taking to a banker is the greater prospect of profits. The marginal cost of risk-taking is the increase in interest demanded by uninsured depositors, the increase in premiums demanded by the deposit insurer and the increase in losses from risks that do not pan out. Because covered depositors are shielded from losses, insurance eliminates the incentive to demand higher interest rates from risky banks. So, with flat-rate deposit insurance premiums, the only check on risk-taking is a bank's net worth. Net worth is the difference between the value of assets and the value of liabilities; it represents the stake the owners have in the bank and operates much like a deductible for insurance coverage. When net worth is high, the owners have much to lose from risks that do not pay off. If net worth falls to zero, however, the owners have nothing to lose, and the marginal cost of risktaking is essentially zero. Under such circumstances, bankers may yield to the temptation to take imprudent risks-- that is, succumb to the moral hazard in deposit insurance.