What is the necessity of the FDIC in the US banking system?

Question

A bank's basic function is to "borrow short and lend long". In other words, it borrows money from depositors over the short term, promising to repay it on demand, while it lends most of that money out over the long term to borrowers, for instance in the form of 30-year mortgages. This difference between these time frames, known as maturity mismatch, leads to systematic problems for banking. It makes banks vulnerable to crises, because if all the depositors show up one day asking for their money, the bank can't give it to them, because it's been lent out to borrowers, so the bank becomes instantly insolvent, even if it had no financial troubles before the depositors were worried about the bank's solvency.

Indeed, this used to happen frequently in the 1800's and early 1900's, most prominently in the Great Depression, until the FDIC came about. The FDIC makes all the banks pay a premium, and in exchange, whenever there's a run on a bank, the FDIC gives the bank money so that it can meet all its depositors' demands (at least up to a cap, like a hundred thousand dollars per account).

My question is, in the absence of the FDIC, why wouldn't banks just obtain private deposit insurance? Whenever people have significant risks, even if they're small, they tend to buy insurance. You don't have a very great risk of dying tomorrow, or having a car accident, or having a flood in your house, but still you buy insurance just in case. Companies of all kinds do the same: stores buy liability insurance, fire insurance, etc. So why wouldn't banks insure their risks similarly?

And it's not like banks don't buy private insurance already. For instance, when they lend out money, they buy insurance in case the borrower defaults on a loan - it's called a credit default swap. (Those were partially responsible for the financial crisis of 2008.) So what reason would they have for not buying insurance in case their depositors' demands exceed their reserves?

Is the problem that the premiums they would have to pay on the free market would be too high to make banking profitable anymore? If that's the case, then does that mean that the FDIC is not charging actuarially fair premiums to banks right now?

Any help would be greatly appreciated.

Thank You in Advance.

Answer 1

You provide a generally correct impression of history (i.e., there were lots of runs on banks by depositors in the US until federal deposit insurance was established— a good history is provided by Gorton (2012)), and then ask three questions: why isn't deposit insurance provided through the private sector, is it because the free market equilibrium premiums would be too high, and if so, does this mean that the FDIC premiums are set too low?

To answer, we should first back up to the reason for deposit insurance generally, which is twofold:

1. Monitoring costs
2. Bank runs are a stable equilibrium

Then, we can discuss the reasons for government provision of deposit insurance specifically, which are:

1. Externalities
2. Monitoring costs (still)
3. Moral hazard
4. Systemic crises

The monitoring costs issue is a real one, and has been discussed in the literature by Diamond (1984), among others. It's derived from a prinicpal-agent issue: foremost, depositors want bank management to make safe investments that ensure that their deposits can be returned with certainty, while bank management is encouraged by its equity holders to take on as much risk as possible (for a general discussion of this principal-agent problem in the theory of the firm, see Hart (2001)). In short, management isn't looking out for depositors, and it's really expensive to ask all depositors to be aware at all times about the state of a bank's investments. This is additionally difficult as a practical matter, as bank balance sheets are not paragons of transparency.

Further, as Diamond and Dybvig (1983) showed, even if one ignores monitoring costs, bank runs are one stable equilibrium of a system without deposit insurance. The logic for this is described in your question: if an institution that holds illiquid assets is forced to liquidate them prior to maturity and within a short time period, it may face solvency issues as a result of that forced liquidation. This is known as the "solvency-liquidity nexus" and is discussed in a context including wholesale funding, as opposed to only deposit funding, in Pierret (2015). As a result, if depositors believe that a bank may face a run, it's rational for depositors to run on that bank even if it is fundamentally solvent. In fact, if one considers that a depositor's only recourse (in the event that monitoring reveals that management is taking on too much risk) is to withdraw his or her deposits, it should be clear that zero-cost monitoring of banks does not eliminate the possibility of runs.

So, why government-provided deposit insurance?

Perhaps the simplest reason, but the one that is least discussed in the literature, is that bank failures tend to occur together, as widespread episodes with significant externalities. For this reason alone, it's easy to understand why society (and on behalf of society, government) would have an interest in ensuring that they don't occur. But that doesn't really answer your question, which is, why doesn't the private sector handle the problem of bank runs through private insurance (and, contra another answer to this question, the private sector has never handled this issue well) so that the problem never becomes one that the government must address?

Well, a second reason would be that depositors would still face monitoring costs, as the value of the liquidity guarantee provided by a private insurer would only be as good as that entity's capacity to make good on its guarantees, which would require monitoring in turn. So that problem would still exist.

A third reason, as Diamond and Dybvig (1983) discussed in their conclusion, is that an insurer must be able to regulate the bank it's guaranteeing, because otherwise, the bank managers again have an incentive to make riskier choices:

The riskless technology used in the model isolates the rationale for deposit insurance, but in addition it abstracts from the choice of bank loan portfolio risk. If the risk of bank portfolios could be selected by a bank manager, unobserved by outsiders (to some extent), then a moral hazard problem would exist. In this case there is a trade-off between optimal risk sharing and proper incentives for portfolio choice, and introducing deposit insurance can influence the portfolio choice. [...] Introducing risky assets and moral hazard would be an interesting extension of our model. It appears likely that some form of government deposit insurance could again be desirable but that it would be accompanied by some sort of bank regulation. Such bank regulation would serve a function similar to restrictive covenants in bond indentures. Interesting but hard to model are questions of regulator "discretion" which then arise.

Given this need for a regulator where deposit insurance exists, it makes quite a bit of sense to build a legal framework around a single regulator-insurer, which we've done in the US in the form of the FDIC and related entities (including Federal Reserve supervision and the OCC). This is largely because market-based regulation of banks by private deposit insurers (such as by allowing insurers to cancel coverage if banks breach certain risk limits) would be difficult (at best) to structure without the broad legal authority the government has to seize control of an institution that breaches risk limits and make necessary changes. If private deposit insurers can't rescind coverage, their ability to discipline banks is limited; if they can, then banks face a likely run if their coverage is rescinded, which solves nothing. It is also, of course, difficult as a practical matter because of the aforementioned opacity of bank balance sheets.

Fourth and finally, as discussed by Caballero (2009a, 2009b), bank failures don't occur in isolation; institutions tend to be impaired at exactly the same moment that other institutions and markets are impaired. While you correctly note that a form of partial insurance is in use (in the form of credit-default swaps) today, it's worth considering what happened during the crisis, when outstanding CDS contracts caused the failure of the insurer AIG.

This leads us to a reasonable question: what would a private deposit insurer look like? We know at least two things. One, it would have to be very well-capitalized, for if it were not, the Diamond-Dybvig "run" equilibrium would still exist. Two, it would have to hold its significant reserves in the form of information-insensitive "safe" assets, most likely government-guaranteed securities, or else it may not be able to liquidate those assets under the conditions that lead to bank failures (which can be accompanied by fire sales and other phenomena that impair asset values).

This leads us to an answer to your second question, which is yes, this would be relatively expensive, as you'd have to insure the whole stack of deposits, rather than allowing the government to provide a tail risk guarantee as it does with the Deposit Insurance Fund (if the FDIC's DIF is run to zero during a crisis, the US government will make up the difference). That tail risk guarantee provided by the government is a conditional put— it costs nothing until the DIF needs a bailout, at which point the government can fund it by issuing debt at the very low rates that prevail (for safe assets) during times of financial distress.

To answer your third question, the DIF has never required a bailout, and its rates are adjusted to prevent it from holding reserves that are too great, so— the FDIC is probably charging an actuarially fair rate over a long time horizon, though the rate may be too high or too low at certain points in time.

Answer 2

A lot has already been written about this topic and there is absolutely no historical evidence that liquidity related problems should occur in a banking system without a deposit insurance (because of some inherent features of the system) or that deposit insurance can prevent these problems.

A book called Fragile by design, published recently by Princeton University Press, shows through historical narrative that there existed banking systems without any kind of deposit insurance (and very little other regulation as well), Scotland in 18th and first half of the 19th century and Canada until the second half of the 20th century, that experienced practically no problems related to liquidity. On the other hand in the USA you had many experiements with deposit insurance (before FDIC) which all just exacerbated these problems (because of moral hazard and the fact that the such system is designed to previlege weak banks).

In today's financial markets it is likely that, as you said, private insurers would offer some kind of insurance to other banks. In historical periods in Scotland and Canada mentioned above no such products were avalible however, the insurance that banks used was either a optional clause on the banknotes that enabled banks to delay the payment of deposits in case of a bank run or an implicit insurance by other banks in the system (who were also interested in maintaining trust in the banking system). Although these mechanism were rarely used as runs on healthy (solvent) banks were rare.

If you are interested in reading more about these historical periods I recommend you to look around the Alt-M (ex free banking) blog or read the books by the scholars who post there, namely George Selgin and Larry White, the former has written a lot about the Scotland's experience with free banking.