Why We Need to Lower the FDIC Deposit Guarantee

The FDIC is bust. The group began 2009 with $30 billion in its insurance fund, but after covering losses at almost 100 insolvent banks so far this year, the fund is now in deficit and will stay in the red until at least 2012.

In 2008, Congress decided to “temporarily” increase the maximum amount of insurable deposits from $100,000 to $250,000 per account. Although the higher limit was set to expire at the end of 2009, Congress has extended it through the end of 2013 to “maintain confidence in the banking system” during the financial crisis. Proponents also argue that the increase is needed to keep pace with inflation, the $100,000 limit having been set in 1980.

These legislative actions were not necessary to protect small depositors — the main objective of deposit insurance. According to FDIC’s own statistics as of June, 2008, 98% of all depositors at FDIC-insured banks were covered by the $100,000 limit. Indeed, the average account balance of all deposits at FDIC-insured banks was $12,665.

The argument about inflation doesn’t bear close examination either. Although the consumer price index has risen roughly 150% since Congress set the insurance limit at $100,000 in 1980, on an inflation-adjusted basis, the initial FDIC limit of $5,000 on deposit insurance in 1934 should have risen to only $30,746 in 1980 and approximately $80,000 in 2008.

When the $250,000 limit was extended to 2013, the White House stated: “this will provide depository institutions with a more stable source of funding and enhanced ability to continue making credit available across the country.” However, there is no proven connection between higher FDIC insurance limits and increased lending by insured banks.

Look back at what happened after the 1980 change. S&L’s that were struggling to obtain funding to cover their liabilities spotted the opportunity to obtain that funding by attracting insured deposits. They offered high interest rates and employed brokers to canvass potential depositors. A few managed to solve their problems by doing this, but a great many more did not and imposed larger losses on the FDIC as a result. A similar pattern has been evident over the last year, as troubled banks have bid up interest rates to attract sufficient deposits to meet their pressing cash flow needs.

The people supplying this “hot” money that seeks out the highest short-term rates offered by weak banks are sophisticated investors who spread large sums among many FDIC-insured banks. By raising the maximum insurance limits from $100,000 to $250,000, Congress has more than doubled the amount they can deposit in the weakest FDIC-insured banks offering the highest interest rates.

What’s more, as a result of the increase in insurable limits to $250,000, regulators have lost the help of a savvy group of private monitors. When insured deposits were limited to $100,000 per account, corporations and wealthy individuals would look closely at the financial condition of a bank before making deposits over that limit. In turn, the executives of the bank would bolster its financial condition to attract monies from such sophisticated depositors.

With a $250,000 limit, however, many of those investors can keep most of their cash in insured deposits. In that case, they no longer have any incentive to scrutinize the financial condition of the bank; if it fails, they will be fully protected by the FDIC. In short, the new $250,000 limit will erode much of the private sector monitoring that could help federal regulators constrain excessive risk-taking by insured banks.

Unless we bring back the lower insurance limits for deposits, the FDIC’s rescue of failed banks could become very expensive. Taxpayers paid over $100 billion to resolve the S&L crisis, and Congress recently authorized the Treasury to lend the FDIC up to $500 billion.

Do you think that the limit on deposit insurance should go back again to $100,000?

Bob Pozen is a senior lecturer at Harvard Business School and the author of Too Big to Save? How to Fix the US Financial System (John Wiley, to be published on November 9, 2009)