Deposit Insurance Undermines Bank Stability

Provisions in both Senate and House bills extending the temporary

coverage cap of $250,000 for deposit insurance until 2015 could be as

damaging as the now defeated "cram-down" provision in the proposed

changes in the bankruptcy code. Extending deposit insurance coverage

helps few families, and those helped are among the wealthiest, while

reducing market discipline on our banking system. As the temporary cap

is in place until December 31st, Congress appears to have plenty of time

to examine and debate the issue.

Tucked away in the TARP bill was in increase in the then $100,000 cap

for deposit insurance to $250,000. That "temporary" cap was set to

decline back to $100,000 on January 1, 2010. With no hearings on the

need for this increase, or any report language on the provision, one is

left to assume Congress believed that depositors would panic and

withdraw their deposits above $100,000 from our banking system in the

absence of this protection.

Who are these supposed panic-prone depositors? Of the 117 million

households in America, only about 10 million have total bank deposits

above $100,000, or less than 9 percent of all American households.

These same families also have incomes of over twice the median, putting

these households in the top 20 percent of earners. Nor are these

households without significant wealth, with total median holdings of

financial assets alone of almost $600,000. Most households with

deposits above $100,000, given their considerable financial wealth,

demonstrate sufficient sophistication to provide monitoring of a bank's

financial condition. Even if families with bank deposits above $100,000

were to suffer a loss in deposits resulting from a bank failure, the

typical family in this group has both considerable income and wealth to

buffer such a hit. In contrast, the typical, or median, American

household, has only about $6,400 in bank deposits, well below the

previous ceiling of $100,000.

Outside of providing public benefits to a small slice of our wealthiest

families, what else comes with extending deposit insurance? Arguably a

more stable banking system; yet a substantial share of other countries

continue to have functioning banking systems in the absence of any

deposit insurance. A recent academic study across over 150 countries

found that, all else equal, those countries with more generous deposit

insurance schemes also suffered more frequent banking crises.

Similar results hold for the US, as various academic studies have found

that U.S. uninsured deposits provide substantial monitoring of bank

health. The related decline in market discipline that results from

deposit insurance has been documented across time and differing

regulatory structures. Few relationships in economics have been found

in so many different settings as the link between expanded deposit

insurance and bank instability.

FDR and the New Deal have been invoked regularly as a model for solving

our current financial crisis. But FDR vocally opposed the creation of

deposit insurance and threatened to veto the Glass-Steagall banking bill

over its inclusion, saying it "would lead to laxity in bank management

and carelessness on the part of both banker and depositor." Ultimately

he signed Glass-Steagall into law, believing its other provisions

out-weighed the potential harm that might follow from the creation of

the FDIC. History continues to confirm FDR's initial fears toward

deposit insurance.

The performance of the Canadian banking system compared to that of the

United States during the Great Depression illustrates the problems of

deposit insurance. The Canadian banking system, which lacked any

deposit insurance during the 1920s and 1930s suffered only one bank

failure in the 1920s, and none in the 1930s. The U.S., with its

state-based deposit insurance system, suffered over 6,000 bank

suspensions and almost 4,000 mergers and acquisitions in the 1920s

alone. The worst of those failures were found in states with the most

generous deposit insurance systems.

There is no reason to believe that extending deposit insurance will not

again undermine market discipline, as it consistently has in the past.

Congress is poised to now undermine the future stability of our banking

system, largely for the benefit of the country's wealthiest families.