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Deposit insurance and monetary stability

Posted by Thomas L. Hogan
March 18, 2015

Government deposit insurance from the Federal Deposit Insurance Corporation (FDIC) is intended to stabilize the financial system by preventing bank runs and financial contagion. As discussed in a previous blog post, however, most evidence indicatest hat  deposit insurance actually increases bank failures. When bank depositors are insured, banks face less monitoring and tend to take excessive risks, a problem known as “moral hazard.”

In a recent working paper, Kristine Johnson and I review three areas of the empirical research on government deposit insurance, each of which finds deposit insurance has actually increased rather than decreased the rate of bank failures.

1. Moral hazard has increased over the history of the FDIC. Higher levels of deposit insurance coverage have led to an increase in the rate of bank failures, and FDIC insurance appears to have played a contributing role in the savings and loan crisis of the 1980s and the 2008 financial crisis.

2. International studies show that higher levels of deposit insurance and higher government involvement in the deposit insurance system both lead to higher rates of bank failure and more frequent financial crises.

3. Prior to the establishment of the FDIC in 1933, several states had their own deposit insurance programs. As with the international literature, studies of pre-FDIC deposit insurance systems find higher levels of coverage and more government involvement had higher rates of bank failure.

In light of the evidence from these studies, we propose three potential reforms to the FDIC system that might increase financial and monetary stability.

1. Deposit insurance could be government mandated but privately administered, as is done in most European countries today. One option might be to administer deposit insurance through the regional Federal Reserve Banks which, like most European systems, are governed their own member banks.

2. The mandated level of deposit insurance coverage could be lowered from its current level of $250,000. This would benefit smaller depositors who might prefer not to pay for deposit insurance but would have the option of purchasing insurance privately through the many providers available today. Reducing the level of coverage would decrease moral hazard in the banking system since large depositors would be unlikely to keep their uninsured deposits at risky banks.

3. Taking the extreme versions of reforms 1 and 2, the FDIC and deposit insurance mandate could be eliminated entirely. Although it is impossible to tell what systems would evolve to help banks minimize risk, the pre-FDIC systems provides some possibilities: clearing houses that regulate the member banks, systems of co-insurance in which banks aid each other in times of crisis, and other risk-prevention mechanisms such as unlimited liability banking and stronger monetary incentives and penalties for bank managers.

Historical evidence indicates these changes would reduce bank failures, benefit the financial system, and improve monetary stability in the United States.

One Comment

  1. vikingvista March 20, 2015 11:19 AM

    Is there no benefit to having *small* depositors also share the risk of their chosen bank’s loan portfolio?

    Rather than eliminate risk sharing for small depositors, wouldn’t it be prudent to eliminate other destabilizing bank regulations in addition to government deposit insurance?