The mess that is deposit insurance

By Felix Salmon
August 16, 2010

There are three reasons to have deposit insurance. The first reason is systemic: it prevents bank runs. There’s no rush to pull your money out of the bank if you know that the government is guaranteeing your deposits. As a result, the entire banking system becomes much more stable and secure.

The second reason is one of simple fairness: depositors shouldn’t be expected to do due diligence on the banks where they deposit their money. And when a bank fails, those depositors shouldn’t lose their money.

The last reason is by far the least noble of the three, but even the FDIC admits that it comes into play when the deposit insurance limit is raised: every time that happens, depositors increase the amount of money they have in bank CDs. So if the government wants to help shore up a rickety banking system, one cheap way of doing so is to increase the FDIC insurance limit. Suddenly, the banks will see an inflow of relatively cheap funds, and will seem to be in much better shape.

So what are the reasons to have a cap on deposit insurance? Why not make it millions of dollars?

One reason is that bank CDs always yield more than Treasury notes, while carrying exactly the same government guarantee. Without a cap on insured deposits, investors would desert the Treasury market in droves, getting the same safety and much higher yields from their local bank.

The second reason is moral hazard. Waving an FDIC guarantee makes it almost too easy for banks to attract deposits. And when every bank has an FDIC guarantee, they’re forced to compete by offering higher and higher interest rates — which in turn forces them to take greater and greater risks with their lending. If the guarantee is set too high, the resulting increased risk in the banking system will more than offset the decreased risk from bank runs.

All of which brings me to Nassim Taleb, who recounts a tale from early 2009:

I was interrupted by Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States, who tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and Prof. Blinder’s company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.

I blurted out: “isn’t this unethical?” I was told in response, “We have plenty of former regulators on the staff,” implying that what was legal was ethical.

The product in question is CDARS, and Blinder is a founder of the company which invented them. When Blinder wrote an op-ed complaining about an attempt to broaden deposit insurance, I was underwhelmed, writing that “Blinder has a massive conflict: he’s the vice-chairman of the company which runs CDARS, a financial instrument designed solely to get around FDIC deposit limits.” Without deposit limits, of course, CDARS become moot, and Blinder loses a large chunk of income.

I first wrote about CDARS back in 2003, shortly after they were introduced, in a Euromoney article which is behind a paywall. I wrote then that Promontory, Blinder’s company, was “doing a job that almost seems as if it should be performed by the Federal Reserve, or some other branch of the government”. But it wasn’t until Bloomberg’s David Evans came along in September 2008 that it became clear exactly what the problem is here:

Promontory charges banks more in fees, about $12.50 per a $10,000 one-year CD to get access to federally insured funds, than the FDIC itself charges in insurance premiums, typically $5-$7 per $10,000 deposited.

Essentially, Promontory is selling an insurance product, and collecting insurance premiums, even though it’s the government, and not Promontory itself, which is providing the insurance. That’s why Taleb calls the whole thing a scam.

In October 2008, the FDIC temporarily raised the insured limit on deposits to $250,000 from $100,000, making it very clear that the limit would come back down to $100,000 at the end of 2009. But in May 2009, the FDIC extended the “temporary” period all the way through the end of 2013. And in July of this year, the inevitable happened, and the $250,000 limit was made permanent.

The increase in the FDIC limit does increase the amount of moral hazard in the system; it also increases the amount of protection that depositors have. It does not meaningfully reduce the chance of bank runs, which is the main reason for FDIC insurance to exist in the first place. But it does help banks to hold onto deposits which would otherwise depart for money-market funds and the like.

While banks were getting all of this lovely support from the government, money-market funds were spending a whopping $12.1 billion to prevent their funds from slipping below the $1 mark, and more than 200 of them would have done so without injections of capital from their parents.

The whole thing is an ad hoc legal and regulatory mess, cobbled together largely on the basis of who has the best lobbyists: one minute it’s Promontory, next minute it’s the banks, and almost never does it seem to be the money-market funds. If you were starting a system from scratch it would never look like this, as can be proven by the fact that products like CDARS don’t exist in other countries, and also by the fact that CDARS don’t have any competition.

The FDIC itself is reasonably serious, these days, about charging realistic premiums for its services. (Premiums were unforgivably set at zero between 1996 and 2006, which isn’t the fault of the FDIC but of Congress.) But with the Dodd-Frank bill now signed into law, root-and-branch reform to the deposit-insurance landscape has become a political impossibility — which is fine by Congress, which loves to be able to meddle in such things when their local bankers ask them nicely.

And when the entire system is as politicized as this, it’s hardly surprising that the likes of Alan Blinder will embark on highly-lucrative regulatory arbitrage. He should probably just avoid trying to sell those schemes to Nassim Taleb in future.


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Deposits should be 100% protected – whether you have 100 dollars in the bank or 100 million.

Posted by Sensei | Report as abusive

>The first reason is systemic: it prevents bank runs.

The thing is, insurance doesn’t pay out immediately. Recent evidence from the UK shows that people prevent to have their money in their hands instead of waiting a couple weeks on the deposit insurance, and so runs are not avoided.

Posted by a.soffronow | Report as abusive

I’m not sure this is entirely new though. What were they called, “fund jockeys”? who would do something similar with S&Ls.

Split up large deposits and place them in $100,000 chunks around the market to make sure that each piece was insured?

Posted by TimWorstall | Report as abusive

Alan Blinder wrote an op-ed with R. Glenn Hubbard in the WSJ in Oct 2008 noting what a bad idea blanket deposit insurance was. And that’s exactly what CDARs provides. So he was, at minimum, being hypocritical or maybe, like everyone these days including regulators and academics, he was talking up his book.

So I think your concerns, Felix, are well-founded as we are seeing more and more “insider-regulator arbitrage” of an increasingly complex financial system. And FinReg is a gift to such arbitrageurs.

And the fact that the CDARs enterprise is almost wholly-owned by a former Comptroller of the Currency should worry us. Including the fact that there is no real competition for the product….

Posted by AABender1 | Report as abusive

“It does not meaningfully reduce the chance of bank runs,” I guess that may be technically true, but higher insurance absolutely increases the assets that the banks maintain. I can assure you that I, for one, will not have any non-guaranteed deposits these days. If the limit were lowered, I’d withdraw money tomorrow. I’d call that a form of a bank run.

By the way, the CDARS stuff is even worse than you probably know – individual banks do it within their own banking charter structure. ie, if you have an account with Citi, they can split it up into a few different DISTINCT Citi holding companies for you – all insured. Why do we even allow them to have multiple distinct holding companies?

Posted by KidDynamite | Report as abusive

I agree with TimWorstall; CDARS may be new, but the concept appeared almost the minute the 3-6-3 regime was deregulated. A significant contributor to the S&L crisis. But Felix touched on that with his mention of competition for deposits.

On a separate note, you cannot make generalizations from the UK example because their deposit insurance is ingeniously constructed to maximize taxpayer liability while minimizing the benefit of preventing bank runs. That is, the bulk of “insured” deposits are only 90% covered. Since nobody wants to lose 10% of their savings, the impact on bank runs is nugatory.

Posted by Greycap | Report as abusive

You are spot on here Felix… my bank uses the CDARS program and it is nothing more than an end run around the FDIC limits. I can vouch that the CDARS product does work… we get notices all the time that our deposits are being moved due to a bank failure. The Notices are sent out on Friday and on Monday we get the notice of the new institution that now holds our 100k for the same rate and same terms as the failed bank.

The whole system is foolish but there is a market for it. We do have customers who want to work only with us and have millions of dollars and want it all insured. Normally we can take care of that with an FDIC approved account scheme where one account is for Mr. Jones, one for Mrs. Jones, one for both Mr. and Mrs. and so on. But that only works up to a million or so. If you’ve got 5 million and want FDIC insurance than you go through CDARS.

And all this for insurance that will never pay out anyway… we are a mutual bank… no stock holders no bonds… 12% capital ratio. 5-star financial strenght rating. We only started offering CDARS when Buffett pulled out of deposit insurance… we use to go through his company Kansas Surety… when they stopped renewing policies across the board CDARS was the only real option… by then all the other insurance companies that offered deposit insurance were on such shakey ground that the insurance would have been worthless.

As a banker I’m all for low insurance limits 100k per normal account and 250k per retirement account. If you’ve got a few million split your money between a few banks… or else give some of it to a professional manager like Bill Gross.

Posted by y2kurtus | Report as abusive

CDARS are a way for small single-entity banks to compete with multi-bank holding companies that offer the same product in-house by splitting the deposit up among their various banking charters.

Why allow multi-bank holding companies to have distinct charters? Because they are required to have distinct charters. Banks have to be chartered by the state they do business in. If they have a national charter, they’re still licensed in each state. They’d probably be happy to consolidate, of the State fees went away.

As to the morality of CDARS or multi-bank splits, that Nassim Taleb seems so upset about, I’d put it on a par with splitting accounts between Mr. Smith, Mrs. Smith, Mr. Smith Rev Trust, Mrs. Smith Rev. Trust, Mr. Smith and son, etc. It is regulatory arbitrage.

I’m not sure what the morality of deposit insurance is, so I’m not sure what the morality of arbitraging its regulatory structure is. When NT can tell me *why* deposit insurance is or is not moral, I will listen to his opinion as to the morality of its arbitrage.

Posted by Publius | Report as abusive

Re Reason #1: as private businesses in competition with one another, banks ought to operate under the fear of bank runs. The reason is that under the banking system long in place — the “fractional reserve” system — banks lend out more than they take in; ergo, every commercial bank is inherently insolvent. Regardless of size of caps, taxpayer-funded insurance of an inherently fraudulent system must lead to moral hazard. What should be done to stabilize the banking system is the opposite: end FDIC altogether and require (under penalty of enforcing fraud laws) that banks inform any new depositor of the following: “whether checking or savings, Mr. Depositor, you are essentially making this bank a LOAN and there is a risk that you may lose your deposit.” Alternatively, one might also legally end fractional-reserve banking and require by law that each dollar have 100% gold backing, and each depositor have the freedom to demand payment in specie for fiat currency on demand. Under such conditions, how eager would a bank really be to inflate its own bank notes in order to make more loans?

That segues to Reason #2: why is it “unfair” that depositors do their own due diligence regarding their own banking but somehow not unfair that they do their own due diligence regarding their own health care, education, automobiles, diet, and love lives? The fact is, people have simply grown used to government doing the due diligence for them in banking (as they will, too, in other areas of their lives if and when government “regulates” and “insures” those as well). Remove government insurance of banks (and the necessary moral hazard it creates) and people will re-learn how to study them critically in exactly the same way they learned how to critically judge doctors, careers, computers, cars, and microwave ovens.

Posted by EconomicFreedom | Report as abusive

Splitting up a large deposit to gain FDIC insurance of the whole is such an obvious loophole that it seems to me that the failure to forbid it indicates tacit approval.

The purpose of deposit insurance is to prevent unmanageable withdrawals of deposits. If a single depositor had $5 million with a single small bank (maybe their rates are the best around?), then the sudden withdrawal of those deposits could be a problem for them. Seems better to have that split up among 50 different institutions.

Posted by TFF | Report as abusive

EF, if you require 100% reserves on deposits, then why would a bank even bother taking deposits? Fractional reserve allows them to loan out part of the money, while keeping a fraction available for withdrawals. If you take that away then you can only loan the capital you own, no more.

Posted by TFF | Report as abusive

Exactly TFF … those who made recomendations for regulation with loopholes and former SEC ‘big guns for hire’ as they go to work for wallstreet. (or as this guy did, take the whole pie) Pretty sweet deals can be made when you have revolving doors.

Posted by hsvkitty | Report as abusive

Worth notiing – Promontory acknowledges having $55Bn in its system. Does someone want to apply the CDARS rate haircut on $55Bn to figure what this is worth in real money?

Posted by TKaz | Report as abusive

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