BlogArt: Do Away with (Public) Deposit Insurance

February 28, 2009

This is why publicly-funded deposit insurance should be banned.  GMAC’s ad for high-yield bank CD…

FDIC insurance creates terribly perverse incentives.  GMAC is insolvent.  It continues to exist only because taxpayers pumped $6 billion into the company at the end of December.  In order to survive, GMAC is offering CD rates 80 bps above the national average.  It’s a desperation move, common of banks nearing their end.  Paying above-market rates of return on deposits makes profitability difficult over the long-term.  But a bank like GMAC cares less about profit than it does about survival.  Remember WaMu’s 5% CD offer right before they went bust in the fall?

Why would depositors put their money in an insolvent bank?  Because it’s FDIC insured!  The bank down the block may be much stronger financially, but if they’re only offering 2% on 1-year CDs, might as well put my money in GMAC.  Quoting part of the pitch:

…a CD from [is] safe, secure and FDIC-insured up to $250,000. Not only that, it also has an incredibly high yield…

Methinks thou dost protest too much, GMAC: “safe,” “secure,” “FDIC-insured” … three adjectives that mean precisely the same thing, all of which designed to conceal the truth, that GMAC is bankrupt.

In the presence of FDIC insurance, most savers see bank deposits as interchangeable commodities.  If they’re all backed by the government, they’re all the same—I might as well go for the one that offers the highest return.

But truth be told, bank deposits are not created equal.  Strong banks deserve your money better than weak banks.  Unfortunately, few bank customers bother to consider this because they don’t think they have to. Their money is “guaranteed.”

No doubt deposit insurance was born of necessity.  Bank runs are to be avoided and most bank customers aren’t sophisticated enough to judge a strong bank from a weak bank.  Hell, given the opacity of banks’ asset values, even sophisticated analysts have difficulty recognizing how weak certain banks are.

The problem with public deposit insurance is two-fold:

  1. It has been MASSIVELY under-priced.  The FDIC’s Deposit Insurance Fund is a tiny fraction of total insured deposits.  0.40% as of December 31st, to be precise.  Banks derive huge value marketing FDIC-guaranteed deposits, for which the FDIC charges FAR too little.   (more on this in a post to come shortly).
  2. Putting the public at risk for the benefit of bankers and their depositors is positively immoral.  If bank depositors want insurance, then have them pay for it themselves.

Heavily-regulated private deposit insurance makes much more sense.  As noted above, deposit insurance is a good thing if it helps to protect the unsophisticated and to stabilize the banking system.  But if folks who take risk wish to be protected from it, they should be the ones to pay for the protection.

Heavy regulation would be necessary to force insurers to maintain substantial capital cushions.  No doubt such a regime would fail from time to time, but that would actually be healthy.  The occassional bank run would remind folks that banks are a risky place to put cash.  It might also prevent banks from growing too large in the first place.

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