The Deposit Insurance Fund
In the wake of the mass failure of depository institutions, Congress passed the Banking Act of 1933, establishing the Federal Deposit Insurance Corporation (FDIC) and giving the federal government the power to insure deposits in qualified banks.
The creation of federal deposit insurance has been tremendously effective in preventing bank runs and keeping the failure of individual banks from affecting the larger economy. Deposit insurance “has succeeded in achieving what had been a major objective of banking reform for at least a century, namely the prevention of banking panics.”
Despite the positive effect of FDIC insurance on preventing bank runs, the implementation of deposit insurance poses aregulatory cost of its own—it gives the shareholders and managers of insured banks incentives to engage in excessive risktaking.
This moral hazard occurs for two reasons. First, bank shareholders are able to foist some of their losses onto innocent third parties.
These third parties are the healthy banks whose contributions to the FDIC pay off depositors of failed banks, and ultimately the federal taxpayers whose funds replenish the federal insurance funds when they are depleted.
Second, moral hazard is also present because “deposit insurance premiums have been unrelated to, or have not fully compensated the FDIC for increased risk posed by a particular bank.” The problem of moral hazard is exacerbated in situations where a bank is at or near insolvency.
In such a situation, the shareholders have a strong incentive to increase risk because they can allocate their losses to third parties while still receiving any gains that might result from the risky behavior.
Companies outside the banking industry that are close to insolvency also have an incentive to take added risks.
The federal government has attempted to replace these market forces with regulatory requirements such as capital requirements.
Higher capital requirements force shareholders to put more of their money at risk, and this reduces moral hazard.
In the context of our previous discussion of contracts, capital requirements allow one set of claimants—the regulators (or deposit insurers)—to impose restrictions on the shareholders.
In the wake of the mass failure of depository institutions, Congress passed the Banking Act of 1933, establishing the Federal Deposit Insurance Corporation (FDIC) and giving the federal government the power to insure deposits in qualified banks.
The creation of federal deposit insurance has been tremendously effective in preventing bank runs and keeping the failure of individual banks from affecting the larger economy. Deposit insurance “has succeeded in achieving what had been a major objective of banking reform for at least a century, namely the prevention of banking panics.”
Despite the positive effect of FDIC insurance on preventing bank runs, the implementation of deposit insurance poses aregulatory cost of its own—it gives the shareholders and managers of insured banks incentives to engage in excessive risktaking.
This moral hazard occurs for two reasons. First, bank shareholders are able to foist some of their losses onto innocent third parties.
These third parties are the healthy banks whose contributions to the FDIC pay off depositors of failed banks, and ultimately the federal taxpayers whose funds replenish the federal insurance funds when they are depleted.
Second, moral hazard is also present because “deposit insurance premiums have been unrelated to, or have not fully compensated the FDIC for increased risk posed by a particular bank.” The problem of moral hazard is exacerbated in situations where a bank is at or near insolvency.
In such a situation, the shareholders have a strong incentive to increase risk because they can allocate their losses to third parties while still receiving any gains that might result from the risky behavior.
Companies outside the banking industry that are close to insolvency also have an incentive to take added risks.
The federal government has attempted to replace these market forces with regulatory requirements such as capital requirements.
Higher capital requirements force shareholders to put more of their money at risk, and this reduces moral hazard.
In the context of our previous discussion of contracts, capital requirements allow one set of claimants—the regulators (or deposit insurers)—to impose restrictions on the shareholders.