On Wednesday, the Federal Deposit Insurance Corporation
announced that the reserves of the Bank Insurance Fund had fallen below the
1.25 percent minimum level. This is the fund that protects bank deposits and
reimburses depositors when banks go out of business. Yet despite the fact
that the FDIC is already overextended, Congress is seeking to expand its
liabilities by increasing deposit insurance.
Deposit insurance was created in 1933 in the wake of massive
bank failures resulting from the Great Depression. Millions of Americans
lost all their savings, contributing significantly to the length and depth
of the depression. With deposit insurance, savers were assured that they
would be protected against loss on up to $5,000 per account -- equivalent to
about $60,000 today.
Over the years, the maximum amount of deposits protected by
insurance has risen to $100,000. It is estimated that this is sufficient to
cover 99 percent of accounts. Moreover, the average amount of money per
account is only about $6,000, and the median value is just half that. In
other words, half of all depositors have $3,000 or less in an insured
Furthermore, it is important to remember that deposit insurance
applies to single accounts in individual banks. Consequently, someone can
have an unlimited number of accounts in different institutions, all covered
by deposit insurance. It is relatively easy for depositors to have even
millions of dollars of deposits covered by federal insurance if they want
This would seem to suggest that there is little need to raise
the maximum level of insured deposits. Yet the House of Representatives
recently voted overwhelmingly to increase it to $130,000 per account. If
this were a costless exercise, it would not be worth commenting on. But it
is not. It can potentially cost banks, depositors and taxpayers a great
Banking experts are almost universal in their belief that the
increase in deposit insurance from $40,000 to $100,000 in 1980 was a
critical contributor to the savings and loan crisis that ultimately cost
taxpayers about $150 billion. That is because it encouraged financial
institutions to make excessively risky loans, many of which went bad.
Depositors were lulled into a false sense of security by the existence of
deposit insurance and put their money into such institutions anyway.
Economists call this "moral hazard," which means that a policy
inadvertently encourages the very behavior it is attempting to protect
against. In this case, an effort to protect deposits actually encouraged
risky lending, leading to defaults and bankruptcies. For this reason,
Federal Reserve Chairman Alan Greenspan has strongly urged Congress not to
raise deposit insurance.
Nevertheless, there is a vigorous effort underway led by small
banks to raise deposit insurance in the name of "fairness." They think it
will be easier for them to compete for deposits against their larger
competitors, which are often viewed by depositors as more stable and less
likely to fail.
The view that depositors are better off at large banks is not
unjustified. In the past, the FDIC has bailed out depositors with accounts
larger than the legal maximum, simply because they were at large
institutions. Meanwhile, deposits above $100,000 were often lost when small
banks failed. This policy was rationalized by the view that a large bank
failure might destabilize the whole banking system, and because it was often
cheaper and easier to pay off all depositors there even if it wasn't legally
In 1991, however, Congress passed legislation prohibiting the
FDIC from paying off uninsured deposits. It also changed the way deposits
are insured. Instead of taxpayers being on the hook, banks now pay fees into
the Bank Insurance Fund, which then pays off depositors if necessary.
Thus, the first effect of raising deposit insurance will be to
increase the pool of insured deposits, which will require banks to pay
higher fees. The Congressional Budget Office estimates that they will pay
$3.5 billion more over the next decade. These higher expenses will have to
be passed along to depositors in the form of larger check and ATM fees,
lower interest on deposits and the further elimination of now-free services.
Small depositors undoubtedly will bear most of the burden of these charges.
Therefore, average people will end up paying so that a very,
very small number of extremely wealthy depositors -- those with more than
$100,000 in cash -- can get an additional $30,000 per account covered by
federal insurance. In short, the poor will be subsidizing the rich.
The case for raising deposit insurance coverage is nonexistent
on substantive grounds. At the same time, the case against raising coverage
is overwhelming. If not for the lobbying prowess of the small banks in
getting corporate welfare for themselves, this issue wouldn't even be under
discussion. The Senate should show some sense for a change and reject the
House-passed deposit insurance bill.