A Reexamination of the Costs and Benefits of Federal Deposit Insurance
Hein, Scott E., Business Economics
Mention of federal deposit insurance evokes two disparate responses in today's financial environment. Bankers and the public seem to view federal deposit insurance in an overall favorable light. While bankers are concerned about increased premiums, they don't seem to favor major changes in our federal deposit insurance system. Business economists and the academic community, on the other hand, are far more critical of the current structure of federal deposit insurance. This paper examines today's federal deposit insurance system by summarizing recent thinking in the area of perceived costs and benefits of federal deposit insurance.
FEDERAL DEPOSIT insurance in the U.S. was given birth in the midst of the Great Depression, with the creation of the Federal Deposit Insurance Corporation (FDIC) in the 1933 Glass-Steagall Banking Act. This federal government program was intended to accomplish two primary aims: (1) protect the "small" depositor from loss of wealth due to bank insolvency problems; and (2) prevent the contagious nature of isolated bank failures from turning into large scale bank runs, thus protecting the payments mechanism in the country. There is little doubt that these two goals have been achieved under our federal deposit insurance system. Since 1993, no federally insured depositor has lost funds as a result of a bank failure, and the only bank runs of any consequence in the U.S. have involved state insurance programs.
In light of such success, it is somewhat remarkable to see the extent of discussion both criticizing and calling for substantial reform in our deposit insurance system, especially in the academic community. The purpose of this paper is to provide an overall review of deposit insurance from the perspective of its costs and benefits.
The general cost/benefit framework developed in public finance provides a useful tool for the analysis of deposit insurance, because it requires a detailed analysis of the somewhat forgotten side of the equation -- the costs associated with the federal deposit insurance system. The general cost/benefit approach is also useful because it suggests a serious reexamination of the benefits of deposit insurance.
THE COSTS OF DEPOSIT INSURANCE
The financial failure of the Federal Saving and Loan Insurance Corporation (FSLIC), the resulting tax burden imposed on the American taxpayer, and the more recent insolvency of the Federal Deposit Insurance Corporation (FDIC) clearly represent explicit costs of the federal deposit insurance system. It was generally believed during the establishment of federal deposit insurance in the early 1930s that the program would be financially self-sufficient. Premiums paid by the depository institutions were to cover the handling of individual depository institution failure. For example, Representative Heurn Steagall (D-AL), May 1933, who was a co-sponsor of federal deposit insurance, stated in Congressional discussion, "I do not mean to be understood as favoring government guaranty of bank deposits. I do not. I have never favored such a plan ... Bankers should insure their own deposits."
This presumption concerning self-sufficiency was obviously incorrect. The American public has been called upon to supplement funds available to one federal deposit insurance agency (the old FSLIC) and to lend funds to the other (the FDIC). The Congressional Budget Office presently estimates that the FSLIC bailout will cost U.S. taxpayers about $215 billion in 1990 dollars. Taxpayers are being forced to pay for the savings and loan failure because the FSLIC insurance fund was insufficient to cover all insured deposits for the savings and loans, as their assets fell markedly in value relative to their liabilities. The fund was simply insufficient to serve it's purpose. Congress and the Bush Administration decided the American public would be better served by rescuing the fund, rather than dealing with the problems of losses to insured depositors. …