Academic journal article Independent Review

Alternatives to the Federal Deposit Insurance Corporation

Academic journal article Independent Review

Alternatives to the Federal Deposit Insurance Corporation

Article excerpt

The financial crisis of 2008 has caused economists to reexamine the forces that stabilize (or destabilize) the financial system in the United States and around the world. Despite much debate, there remains serious disagreement as to the root causes of the crisis and hence to the best solutions for preventing future crises. Some studies claim the crisis was caused by deregulation in the financial sector (Crotty 2009; Bhide 2011), but the quantity and complexity of financial regulations had in fact increased significantly in the decades leading up to the crisis. Other studies, by contrast, argue that poor or misguided financial regulations were themselves a major cause of the crisis (Calomiris 2009; J. Friedman 2011). The form of potentially misguided financial regulation that we focus on here is government-administered deposit insurance, managed in the United States by the Federal Deposit Insurance Corporation (FDIC). This paper discusses the evidence from U.S. history and around the world that government deposit insurance leads to more bank failures and financial crises. We consider changes that might be made to the FDIC and the U.S. deposit insurance system to help stabilize the banking system and prevent future financial crises.

Many people are unaware that deposit insurance can reduce stability in the banking system. The literature in support of deposit insurance is based largely on theoretical models (e.g., Diamond and Dybvig 1983). (1) This line of research assumes banking is inherently unstable and that the government has special powers or privileges that enable it to prevent bank runs when private actors cannot. Deposit insurance is often modeled as an idealized and actuarially fair system that prevents crises without creating any harm to the economy. (2) More realistic models, however, include the disadvantages of deposit insurance, such as the problems of moral hazard and increased risk taking that occur when depositors' funds are guaranteed because the depositors no longer have strong incentives to monitor banks' risk-taking activities. From theory alone, it is unclear whether government deposit insurance should be expected to reduce the number of bank failures by preventing runs or to increase the number of bank failures because of moral hazard. We must therefore turn to the empirical studies that analyze the effects of deposit insurance in the real world.

Despite the common perception among both laymen and economists that deposit insurance helps stabilize the banking system, most empirical studies find that deposit insurance decreases stability. After briefly discussing the history of the FDIC, we analyze two strands of the empirical literature. First, international studies of deposit insurance systems around the world indicate that countries with higher levels of deposit insurance coverage and countries with more government involvement in the administration of deposit insurance tend to have higher numbers of bank failures and more frequent financial crises. Second, studies of the banking system in the United States prior to the establishment of the FDIC show similar results. Many U.S. states established their own deposit insurance systems through public or private means, especially prior to the nationalization of the U.S. banking system during the Civil War. Other states evolved competing private systems of insurance or functioned efficiently with no deposit insurance system at all. These private, pre-FDIC systems were effective at regulating the financial system, bailing out troubled banks, and preventing contagious bank runs that could lead to financial crises. Overall, the evidence indicates that reducing the FDIC's role in deposit insurance is likely to increase stability in the U.S. banking system.

Given this evidence, we next consider three potential changes to the FDIC system. First, the administrative side of deposit insurance can be improved by replacing the FDIC with a privately managed organization, as is the case in most developed nations. …

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