Rethinking Which Accounts Qualify For Deposit Insurance

The dollars in our wallets are maintained by the Federal Reserve, and, as the sign on the door to every institution insured by the Federal Deposit Insurance Corporation (FDIC) reminds us, our “deposits are backed by the full faith and credit of the United States government.” For most purposes, currency in circulation is a direct substitute for funds deposited in a bank account. A deposit is only good if it can be redeemed into currency, which depends on the solvency of the depository. The FDIC safeguards the nation’s depositors by pledging to pay out all insured deposits in the event that the private depository is met with illiquidity or insolvency.

The FDIC does not receive direct congressional funding. Depository institutions pay premiums into a deposit-insurance fund, which is used to pay for any losses caused by an insolvent bank. Most of these losses are the insured deposits held by a failed bank, as well as any administrative costs of managing a failed bank held in receivership. As a result, defining which deposits qualify for insurance is of prime importance for the FDIC’s operations.

Section 1506 of the Dodd-Frank Act of 2010 required that a study be commissioned on core deposits and brokered accounts. The goals of this study were twofold. First, Congress wanted to reassess the definition of a “core deposit” used for the purpose of calculating the insurance premium assigned by the FDIC. Second, a closer look at the relationship between core deposits and the larger US economy was warranted, particularly concerning any stabilizing effects that could accrue to the banking sector by redefining core deposits.

In this paper I look at why deposit insurance exists, and to what extent different financial accounts should be insured. I construct alternative criteria to gauge the appropriateness of a funding source’s coverage by the FDIC and conclude with some further policy changes that would reduce the costs of insurance and promote the stability of the banking sector, as well as the broader financial arena.

I. Why Deposit Insurance?

Congress established the FDIC in 1933 as a response to widespread bank failures during the Great Depression. In a bid to restore confidence in the financial system, the federal government pledged to safeguard deposits through deposit insurance. The Federal Deposit Insurance Act of 1933 obliges the payment of deposit insurance “as soon as possible” to mitigate any disruption caused by a bank failure. These payments are enabled through the deposit-insurance fund, as well as through an emergency line of credit from the US Treasury if necessary. To its credit, no depositor has ever lost a penny of insured deposits in the FDIC’s history, and payouts to insured depositors generally happen within one business day.

One unfortunate side effect of a fractional-reserve banking system is the omnipresent possibility of bank illiquidity. A bank takes on deposits that are payable on demand while financing the asset side of its balance sheet with securities (typically loans) of longer maturity. Using short-term deposits to fund longer-term investment projects leaves banks open to the risk that new funding will not be renewed (or rolled over), thus rendering the bank illiquid. A bank will not generally be exposed to the illiquidity of the maturity mismatch it generates so long as withdrawals are largely uncorrelated with one another. Given the law of large numbers, on any given day only a small percentage of total depositors demand their funds. There remains a possibility, however, that a sufficient number of depositors will claim their funds simultaneously and the bank will become illiquid. The mix of illiquid assets with liquid liabilities can give rise to panics among depositors fearful of suffering a loss on their deposited funds. This incentive holds regardless of the actual financial position of the bank, as any fractional-reserve bank will be exposed to illiquidity and cannot perfectly predict when and to what extent depositors will make withdrawals.

The FDIC provides insurance to remove the possibility of a bank run. By guaranteeing a deposit to a sufficient amount, the FDIC has effectively eliminated the possibility of a bank run, because no depositor need worry that his funds will not be paid back on demand and at par value.

While deposit insurance solves the apparent problem of depositors withdrawing their funds en masse, it creates the secondary problem of moral hazard. Removing the threat of losses diminishes the incentive for a depositor to monitor the financial position of his bank. (Perhaps unsurprisingly, the first states in the United States to experiment with mandated deposit-insurance plans were also those with poorly capitalized, state-chartered banks.) In response, the FDIC also undertakes a monitoring and regulating role of the financial system to ensure that its potential payouts are minimized. It does so through two avenues, one active and the other passive.

The FDIC actively monitors the risk-based capital ratios of insured banks. When a bank’s capital ratio falls below 8 percent, it is given a warning. A drop below 6 percent can result in a mandated change of management or a forced corrective action. Finally, when the bank’s capital ratio falls below 2 percent, it is termed “critically undercapitalized,” the institution is closed, and the FDIC is appointed as the receiver of the bank. In this role the FDIC must resolve the failed institution and pay out the guaranteed amount to insured depositors.

The FDIC also passively monitors banks by limiting the types and amounts of liabilities it will guarantee. By limiting insurance to “core deposits,” it leaves large depositors and holders of noncore deposits exposed to potential losses. This exposure creates an incentive for these depositors (and lenders) to monitor a bank’s investment portfolio, and to allocate capital to only those banks deemed sufficiently strong to make good on their liabilities. Therefore, it is critically important that the FDIC accurately define which bank liabilities constitute core deposits. A sufficient amount must be included to remove the incentive for a bank run, but guaranteeing too many noncore deposits will reduce the incentive for depositors to aid in the monitoring of depository institutions and lead to an unnecessary increase in moral hazard.

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