Raising Bank Deposit Insurance

Posted: Jun 14, 2002 12:00 AM
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 account. 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 it. 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 deal. 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 required. 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.