Academic journal article Economic Commentary (Cleveland)

Who Benefits from Increasing the Federal Deposit Insurance Limit?

Academic journal article Economic Commentary (Cleveland)

Who Benefits from Increasing the Federal Deposit Insurance Limit?

Article excerpt

Who might stand to benefit from doubling the insured-deposit limit to $200,000, and are such benefits consistent with the social objectives of federal deposit insurance?

Spawned by a compromise to ensure passage of the Glass-Steagall Act in 1933, federal deposit insurance is one Depression-era program that is likely to remain part of the financial landscape for the foreseeable future. But pressure to reconsider its role in the U.S. financial system is mounting. The Gramm-Leach-Bliley Act (GLBA) is dismantling many of the statutory limits on financial consolidation that were the heart and soul of Glass-Steagall, altering the face of the financial services industry. GLBA and the Reigle-Neal Act (1994), which dismantles interstate branching restrictions, promise increased integration of financial markets and more competition among financial firms. Heightened competition in funding markets has prompted some banking associations and policymakers to recommend raising the deposit insurance limit to $200,000.

In March 2000, the Federal Deposit Insurance Corporation (FDIC) began to formally consider this proposal and other reforms. It issued an options paper in August 2000, whose purpose was "to frame the issues confronted by the FDIC and begin the discussion of options for addressing those issues."' Any discussion of federal deposit insurance and the proposed reforms to the current system needs to address two basic questions. First, what are the net social benefits of providing federal guarantees for bank and thrift deposits? Second, given that we have decided a system of federal deposit insurance improves social welfare, how can we structure the system of guarantees to deliver the benefits most effectivelythat is, at the lowest cost to society?

To answer these questions, we must first clarify our motives for providing deposit guarantees. In other words, we must understand why the market outcome is deemed unsatisfactory and what the social objectives we hope to achieve through government intervention are. Such an analysis is important because the structure of our system of federal deposit guarantees is likely to be different if the social objective is to protect small savers, subsidize the funding of bank assets, or stabilize the banking system. In addition, identifying and understanding the social objectives for .deposit insurance is essential for assessing the net social benefits of the various reform proposals, including changes in the insured-deposit limit. This Economic Commentary seeks to shed light on the issue of deposit insurance coverage by examining who would benefit from increases in the insureddeposit limit.2 Potential benefits to three sets of stakeholders---depositors, community banks, and taxpayers--are discussed. Understanding who stands to gain from increases in the insured-deposit limit helps to ascertain whether such an increase is consistent with the social welfare objectives we establish for federal deposit guarantees.

* Benefits to Small Savers

Proponents of federal deposit insurance argue that it provides two social benefits. First, they claim it improves economic efficiency. With deposit insurance, the deposit insurer can monitor the condition of banks more costeffectively than many small depositors, spread out around the country, can. Second, they claim that deposit insurance creates a more equitable banking market for small savers. Proponents of deposit insurance argue that it is neither reasonable nor fair to expect small savers to monitor banks. After all, it is common to presume, correctly or not, that small savers are financially unsophisticated and lack the ability to assess the condition of a firm whose portfolio of assets consists largely of information-intensive assets-loans. Moreover, even if small savers are financially savvy, the costs of monitoring a bank for them may outweigh the benefits and therefore, it may be rational for them to not actively monitor the condition of their bank. …

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