FDIC Deposit Insurance, Moral Hazard, and Boom-and-Bust Cycles

Examining the dangers of federal deposit insurance in light of the Silicon Valley Bank collapse

The sudden collapse of Silicon Valley Bank and the response of regulators have reignited debates about federal deposit insurance and its dangers. First, some background information. On Friday, March 10, 2023, Silicon Valley Bank was shut down, and the Federal Deposit Insurance Corporation (FDIC) was appointed receiver. On the following Monday, the FDIC said in a press release that “today [the FDIC] transferred all deposits—both insured and uninsured—and substantially all assets of the former Silicon Valley Bank of Santa Clara, California, to a newly created, full-service FDIC-operated ‘bridge bank’ in an action designed to protect all depositors of Silicon Valley Bank. . . . All depositors of the institution will be made whole.”

The FDIC took the unusual action to guarantee all insured and uninsured deposits at Silicon Valley Bank under “systemic risk” emergency powers. The agency’s current insurance coverage limit in ordinary circumstances is $250,000 per depositor, per FDIC-insured bank, per account type such as checking, saving, money market deposit, or certificate of deposit. Federal regulators also decided to fully protect all depositors at New York’s Signature Bank, which regulators shuttered on March 12. Speculation has swirled since whether full depositor protection is now the de facto policy going forward.

The problems with government-mandated deposit insurance have been long recognized and discussed by economists and others. Warren C. Gibson, an economist with the American Institute for Economic Research, describes the pitfalls of deposit insurance:

Deposit insurance generates moral hazard: an incentive to engage in more reckless behavior when one’s misdeeds are covered by someone else. Bank managers tend to make riskier loans than they would without insurance, and depositors don’t worry about the lending practices of the banks they patronize. Currently many people, including me, buy bank certificates of deposit through online brokers, perhaps not even learning the name of the bank that got our money. The magic letters FDIC are all we look for.

President Franklin Roosevelt, who signed the New Deal era law that established the FDIC in June 1933, said in March 1933 that he agreed with Herbert Hoover that deposit insurance would result in more risky behavior:

I can tell you as to guaranteeing bank deposits my own views, and I think those of the old administration. The general underlying thought behind the use of the word “guarantee” with respect to bank deposits is that you guarantee bad banks as well as good banks. The minute the government starts to do that the government runs into a probable loss. . . . We do not wish to make the United States Government liable for the mistakes and errors of individual banks and put a premium on unsound banking in the future.

But that is exactly what has happened.

Deposit guarantees generate moral hazard—riskier behavior in the banking sector. Federal deposit insurance does not guarantee bank profits, but it does incentivize executives to take socially excessive risks knowing that depositor losses will be backstopped to the limit established by the federal government. After seeing regulators’ responses to the collapse of Silicon Valley Bank and Signature Bank, it would be understandable to conclude that, effectively, there is no upper coverage limit anymore. (For a numerical example of how deposit insurance incentivizes riskier actions by bank executives, see Matt Levine’s column “SVB Took the Wrong Risks.”) Riskier investment decisions by bank executives often fuel more severe boom-and-bust business cycles, with risks building over time as deposit coverage limits have been increased.

Among the excessive risks at Silicon Valley Bank was the decision by executives to invest 55 percent to 60 percent of bank assets in fixed-income securities, such as long-term U.S. government bonds, exposing the bank to severe interest-rate risk (also called duration risk) at a time when the Federal Reserve was hiking interest rates significantly in an effort to tame inflation. When duration risk exploded, the bank became heavily exposed to liquidity-risk failure if a bank run occurred, which happened quickly among the bank’s well-informed, herd-like depositors. As one experienced banker has remarked, “Risk is the price you never thought you would have to pay,” but Silicon Valley Bank shareholders paid a high price.

Many prominent historians of money and banking have criticized government deposit insurance. George A. Selgin, a senior fellow and director emeritus of the Center for Monetary and Financial Alternatives at the Cato Institute and a professor emeritus of economics at the University of Georgia, opined in 2022, “Deposit insurance was a way to collectivize losses; but it did nothing to reduce them. On the contrary: by introducing moral hazard it made things worse. Hence the failure of so many state deposit insurance schemes.”

Lawrence H. White, a professor of economics at George Mason University and a research fellow with the Independent Institute, testified to Congress in 2011:

Federal deposit insurance, since its birth in the 1930s, has meant that a comparatively risky bank (one with capital less adequate to cover potential losses on its asset portfolio) no longer faces a penalty in the market for retail deposits. Insured depositors have no incentive to shop around for a safe bank, so they no longer demand a higher interest rate to give it their deposits. Risk-taking is thereby effectively subsidized. Attempts to price deposit insurance according to risk, so as to recreate a penalty for holding a riskier bank portfolio, were mandated by the FDIC improvement act, but the attempt has failed. The FDIC insurance fund has been exhausted by bank failures, and now has a negative balance. Taxpayers are on the hook for the morally hazardous banking that the FDIC has fostered. Some way of rolling back and ultimately ending federal deposit insurance must be found. . . .

[T]he U.S. banking system in the 21st century is chronically weakened by government privileges (especially taxpayer-backed deposit insurance and taxpayer-backed “too big to fail” bailouts) that generate moral hazard. Banks take advantage of these guarantees by holding asset portfolios too full of default risk and interest-rate risk. They finance their portfolios with excess leverage (too much debt, not enough equity). Rather than trying to come up with another patch, Congress should seek to dismantle the restrictions and the privileges that have left the American people saddled with an unhealthy banking system.

Scott B. Sumner, the Ralph G. Hawtrey Chair Emeritus of Monetary Policy at the Mercatus Center at George Mason University and a research fellow with the Independent Institute, noted in March 2023,

Deposit insurance gives bank executives an incentive to take socially excessive risks. In some cases the risks won’t pay off. But that doesn’t mean executives don’t have an incentive to take excessive risks. . . . “Heads I win, tails, part of my losses are borne by taxpayers.” Of course I’d take more risk with those odds. . . . Abolish deposit insurance.

This also was the view of American economist Murray N. Rothbard, who advocated in 1995 for “the abolition of the already bankrupt Federal Deposit Insurance Corporation. The very concept of ‘deposit insurance’ is fraudulent; how can you ‘insure’ an entire industry that is inherently insolvent? It would be like insuring the Titanic after it hit the iceberg.” (For more on Rothbard’s views of government deposit insurance, see Murray Rothbard Was Right: Deposit “Insurance” Is Not Insurance at All.)

The federal government has generated ever-greater morally hazardous banking practices by increasing the FDIC coverage limit over time, beginning in 1934 when the program started:

  • January 1934: FDIC limit set at $2,500 ($54,000 in current dollars) in response to the Great Depression
  • July 1934: limit raised to $5,000 ($109,000 today) in response to the Great Depression
  • September 1950: limit raised to $10,000 ($121,000)
  • October 1966: limit raised to $15,000 ($135,000) in response to survey results
  • December 1969: limit raised to $20,000 ($159,000)
  • November 1974: limit raised to $40,000 ($237,000) in response to inflation
  • March 1980: limit raised to $100,000 ($355,000), a dramatic response to high inflation in the 1970s
  • October 2008: limit raised to $250,000 ($340,000) in response to the Great Recession + “too big to fail” in full bloom with the U.S. Department of the Treasury establishing several programs under the $475 billion Troubled Assets Relief Program (TARP), the largest program was intended to stabilize banking institutions, and the Federal Reserve conducted unprecedented policy interventions including lending programs established for struggling financial institutions
  • March 2023: No limit anymore? FDIC fully protects all depositors, both insured and uninsured + U.S. Department of the Treasury makes available up to $25 billion from the Exchange Stabilization Fund + Federal Reserve creates a new Bank Term Funding Program offering loans to financial institutions that pledge assets as collateral

Certainly, the next time a bank is in a similar position as Silicon Valley Bank or Signature Bank, depositors will expect identical treatment from regulators, and political pressure for such treatment will be unrelenting (one study estimates that hundreds of banks could be nearing similar positions). If bank executives act as though full depositor protection is now the rule going forward, moral hazard will increase, and riskier investment and operating decisions will follow.

Federal lawmakers of both political parties have created an unhealthy banking system by stacking ever-greater moral hazards over time. Because of “too-big-to-fail” bailouts and “systemic-risk” deposit guarantees, ordinary people are paying the price for the resulting moral hazard with fragile banks, distorted investment decisions (malinvestments), and never-ending boom-and-bust cycles of the economy. It is past time to abolish government deposit insurance.

Lawrence J. McQuillan is a Senior Fellow and Director of the Center on Entrepreneurial Innovation at the Independent Institute. He is the author of the Independent book California Dreaming.
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