VIEWPOINT: Deposit Insurance a Persistent Problem

By Pollock, Alex J. | American Banker, October 7, 2009 | Go to article overview

VIEWPOINT: Deposit Insurance a Persistent Problem


Pollock, Alex J., American Banker


Byline: Alex J. Pollock

In the last really big U.S. financial bust, that of the 1980s, the nature and role of deposit insurance in creating the problems was widely and prominently debated. After the public admission that, on top of hundreds of insolvent thrifts, the Federal Savings and Loan Insurance Corp. was itself insolvent, Congress declared that deposit insurance was explicitly a full faith and credit obligation of the United States. This it had never previously been.

By contrast, the role of deposit insurance in the 21st-century bubble and bust was hardly discussed at all, except to keep increasing FDIC coverage and guarantees. Discussion picked up recently, as it became apparent that the FDIC's insurance fund was dramatically shrinking. Now that the FDIC has announced that it is insolvent - i.e., its net worth is negative - naturally it has become a hot topic. But it has not yet reached the point, as it did 20 years ago, of questioning the nature and wisdom of government deposit guarantees as a policy matter.

Federal deposit insurance was created by the Banking Act of 1933, under the guidance of the famous pair, Sen. Glass and Rep. Steagall, the chairmen of the respective banking committees. The following quotations are what they thought about the role of the government in deposit insurance, with a related explanation from another senator of the day.

Sen. Glass: "This is not a government guarantee of deposits. The government is only involved in an initial subscription to the capital of a corporation that we think will pay a dividend to the government on its investment. It is not a government guarantee."

Congressman Steagall: "I do not mean to be understood as favoring a government guarantee of bank deposits. I do not. I have never favored such a plan. Bankers should insure their own deposits."

Sen. Bulkley: "There was a very definite appeal from bankers for the United States government itself to insure all bank deposits so that no depositor anywhere in the country need have any fear....Such a guarantee as that would indeed have put a premium on bad banking."

Seven decades later, we find in all banks the current version of the FDIC sticker, which prominently features the commitment the creators of deposit insurance thought they were avoiding: "Backed by the full faith and credit of the United States government."

If we view the matter from the "30,000 feet" perspective, a fundamental contradiction involved in all modern financial systems is apparent.

On one hand, there is the fervent political desire to make deposits riskless for the public, so that depositors do not need to know anything about or care about the soundness of their bank. But their deposits fund businesses that are inherently very risky, highly leveraged and cyclically subject to much greater losses than anyone imagined possible.

The combination of riskless funding with risky businesses is inherently impossible. The attempt is made to achieve the combination through regulation, but this inevitably fails.

Governments are therefore periodically put in the position of desperately wanting to transfer losses from the banks to the public, as once again in this cycle. …

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