Deposit Insurance: The Forgotten Moral Hazard

Some members of Congress want to make permanent the “emergency” expansion of deposit insurance (in fact, the government guaranty of bank deposits) to $250,000 per person per bank.  Moreover, important provisions of the Senate and House regulatory expansion bills which deal with large non-bank financial companies are modeled on the FDIC.

Where do the members of Congress get the idea that the FDIC is a success?

First, it is insolvent.  The FDIC’s capital is about negative $20 billion.  It is thus dependent on the U.S. Treasury, i.e. taxpayer, guaranty of its obligations.  In original design, the FDIC was not supposed to need or have such a guaranty, but it does and does. If it were itself a bank, it would of course be closed down.

Second, the flow of government insured deposits is what allowed the banking system to inflate the bubble in commercial real estate, which has now collapsed with huge losses.  The result is the failure of hundreds of banks (the most intensely regulated of companies).

The moral hazard of the government’s guaranty of Fannie Mae and Freddie Mac has received much deserved attention.  But the equal moral hazard of deposit insurance, which got so much focus during the financial crisis of the 1980s, has been forgotten this time.  Why? 

The moral hazard of the FDIC is a fundamental problem. But it is not addressed anywhere in the “reform” efforts of the administration or the Congress—except for attempts to expand it even more.