Deposit Insurance Undermines Bank Stability

This article appeared on on May 7, 2009.

Provisions in both Senate and House bills extending the temporarycoverage cap of $250,000 for deposit insurance until 2015 could be asdamaging as the now defeated "cram-down" provision in the proposedchanges in the bankruptcy code. Extending deposit insurance coveragehelps few families, and those helped are among the wealthiest, whilereducing market discipline on our banking system. As the temporary capis in place until December 31st, Congress appears to have plenty of timeto examine and debate the issue.

Tucked away in the TARP bill was in increase in the then $100,000 capfor deposit insurance to $250,000. That "temporary" cap was set todecline back to $100,000 on January 1, 2010. With no hearings on theneed for this increase, or any report language on the provision, one isleft to assume Congress believed that depositors would panic andwithdraw their deposits above $100,000 from our banking system in theabsence of this protection.

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

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

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

FDR and the New Deal have been invoked regularly as a model for solvingour current financial crisis. But FDR vocally opposed the creation ofdeposit insurance and threatened to veto the Glass-Steagall banking billover its inclusion, saying it "would lead to laxity in bank managementand carelessness on the part of both banker and depositor." Ultimatelyhe signed Glass-Steagall into law, believing its other provisionsout-weighed the potential harm that might follow from the creation ofthe FDIC. History continues to confirm FDR's initial fears towarddeposit insurance.

The performance of the Canadian banking system compared to that of theUnited States during the Great Depression illustrates the problems ofdeposit insurance. The Canadian banking system, which lacked anydeposit insurance during the 1920s and 1930s suffered only one bankfailure in the 1920s, and none in the 1930s. The U.S., with itsstate-based deposit insurance system, suffered over 6,000 banksuspensions and almost 4,000 mergers and acquisitions in the 1920salone. The worst of those failures were found in states with the mostgenerous deposit insurance systems.

There is no reason to believe that extending deposit insurance will notagain undermine market discipline, as it consistently has in the past.Congress is poised to now undermine the future stability of our bankingsystem, largely for the benefit of the country's wealthiest families.