Deposit Insurance Undermines Bank Stability

Provisions in both Senate and House bills extending the temporary coverage cap of $250,000 for deposit insurance until 2015 could be as damaging as the now defeated “cram-down” provision in the proposed changes in the bankruptcy code. Extending deposit insurance coverage helps few families, and those helped are among the wealthiest, while reducing market discipline on our banking system. As the temporary cap is in place until December 31st, Congress appears to have plenty of time to examine and debate the issue.

Tucked away in the TARP bill was in increase in the then $100,000 cap for deposit insurance to $250,000. That “temporary” cap was set to decline back to $100,000 on January 1, 2010. With no hearings on the need for this increase, or any report language on the provision, one is left to assume Congress believed that depositors would panic and withdraw their deposits above $100,000 from our banking system in the absence of this protection.

Outside of providing public benefits to a small slice of our wealthiest families, what else comes with extending deposit insurance?

Who are these supposed panic-prone depositors? Of the 117 million households in America, only about 10 million have total bank deposits above $100,000, or less than 9 percent of all American households. These same families also have incomes of over twice the median, putting these households in the top 20 percent of earners. Nor are these households without significant wealth, with total median holdings of financial assets alone of almost $600,000. Most households with deposits above $100,000, given their considerable financial wealth, demonstrate sufficient sophistication to provide monitoring of a bank’s financial condition. Even if families with bank deposits above $100,000 were to suffer a loss in deposits resulting from a bank failure, the typical family in this group has both considerable income and wealth to buffer such a hit. In contrast, the typical, or median, American household, has only about $6,400 in bank deposits, well below the previous ceiling of $100,000.

Outside of providing public benefits to a small slice of our wealthiest families, what else comes with extending deposit insurance? Arguably a more stable banking system; yet a substantial share of other countries continue to have functioning banking systems in the absence of any deposit insurance. A recent academic study across over 150 countries found that, all else equal, those countries with more generous deposit insurance schemes also suffered more frequent banking crises.

Similar results hold for the US, as various academic studies have found that U.S. uninsured deposits provide substantial monitoring of bank health. The related decline in market discipline that results from deposit insurance has been documented across time and differing regulatory structures. Few relationships in economics have been found in so many different settings as the link between expanded deposit insurance and bank instability.

FDR and the New Deal have been invoked regularly as a model for solving our current financial crisis. But FDR vocally opposed the creation of deposit insurance and threatened to veto the Glass-Steagall banking bill over its inclusion, saying it “would lead to laxity in bank management and carelessness on the part of both banker and depositor.” Ultimately he signed Glass-Steagall into law, believing its other provisions out-weighed the potential harm that might follow from the creation of the FDIC. History continues to confirm FDR’s initial fears toward deposit insurance.

The performance of the Canadian banking system compared to that of the United States during the Great Depression illustrates the problems of deposit insurance. The Canadian banking system, which lacked any deposit insurance during the 1920s and 1930s suffered only one bank failure in the 1920s, and none in the 1930s. The U.S., with its state-based deposit insurance system, suffered over 6,000 bank suspensions and almost 4,000 mergers and acquisitions in the 1920s alone. The worst of those failures were found in states with the most generous deposit insurance systems.

There is no reason to believe that extending deposit insurance will not again undermine market discipline, as it consistently has in the past. Congress is poised to now undermine the future stability of our banking system, largely for the benefit of the country’s wealthiest families.

Mark A. Calabria is director of financial regulation studies at the Cato Institute in Washington DC.