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

Moral hazard compounded the problems of the state deposit-insurance programs. Because all covered banks paid the same fixed-percentage premiums, the deposit insurance programs did not deter risk-taking. Because insured depositors, confident in their state's program, did not demand higher interest rates from risky institutions, depositor discipline did not deter risk-taking. Because state bank examiners lacked the resources to force banks to act conservatively, government supervision did not deter risk-taking. Insured banks could make risky loans with relative impunity -the marginal cost of risk-taking was low. Imprudent lending helped produce high default rates, widespread bank failures and bankrupt deposit-insurance funds. As a contemporary commentator noted about one state's program, "It gave the banker with little experience and careless methods an equality with the manager of a strong and conservative institution. Serene in the confidence that they could not lose, depositors trusted in the guaranteed bank. With increased deposits, the bank extended its loans freely."5

Did the Feds Do Any Better?

When designing a federal deposit-- insurance program, Congress sought to avoid the problems that had brought down the state systems. To combat adverse selection, Congress insisted that all national banks and members of the Federal Reserve System accept coverage -thereby preventing larger, and typically stronger, banks from opting out. The nationwide scope of the program also reduced the likelihood that a geographic or industry shock-like the collapse of agricultural prices in the 1920s-would bankrupt the insurance fund. To combat moral hazard, the new program required that insured banks undergo regular federal safety and soundness examinations. As a further check, Congress limited entry into banking markets. Limits on entry shielded existing banks from competition, allowing them to reap high profits and build up net worth. High net worth, in turn, made bankers think twice about undertaking risky activities. Put another way, close government scrutiny and stiff entry barriers deterred risk-- taking by increasing the marginal cost. Federal insurance of thrift deposits also began in the 1930s with the creation of the FSLIC, the Federal Savings and Loan Insurance Corp. The savings and loan deposit-insurance program was similar to the program administered by the FDIC.

Moral Hazard Redux: The S&L Crisis

Although the federal deposit insurance system improved on the state-run programs, it did not eliminate moral hazard. Premiums were, once again, set at a fixed percentage of an institution's deposits. Because premiums were not tied to failure risk, the deposit insurance system imposed no marginal cost on risk-taking. Only the net worth of insured institutions and the watchful eye of bank and thrift supervisors held excess risk-taking in check.

A dramatic rise in interest rates in the late 1970s and early 1980s triggered massive moral hazard in the thrift industry and paved the way for the collapse of the thrift deposit insurance program.