Why is it wise to provide insurance for bank deposits?

The Federal Deposit Insurance Corporation (FDIC) was established in 1933 to help protect deposits. In the early 1930s, nearly 4,000 banks failed. Many banks failed because of depositor “runs” on banks, when huge numbers of depositors demanded their money at the same time. Many financially sound and prudently run banks experienced runs when rumors of a bank failure caused people to panic and withdraw their deposits. Congress established the Federal Deposit Insurance Corporation (FDIC) to protect individual depositors but also to restore confidence in the banking system. All federal banks must be insured by the FDIC. Banks, such as state banks, that are not members of the Federal Reserve System may be covered under FDIC. Today, the FDIC insures depositors up to $250,000 for each account. The Federal Savings and Loan Insurance Corporation (FSLIC) was established soon after the FDIC to extend the same protection to depositors in savings and loan associations.

The news media widely reported the savings and loan failures of the 1980s, many of which were caused by the collapse of the real estate and construction industries, particularly in Texas and California. As developers and managers of real estate and construction companies were unable to repay their loans, many savings and loans or banks had financial difficulties or failed. Most of their depositors, protected by the FDIC or FSLIC, were repaid up to $250,000 per account. The FSLIC did not have enough money to pay all depositors of failed S&Ls, and thus the FSLIC was combined with the FDIC, the insurer of bank deposits. In 1989 Congress created the Resolution Trust Corporation (RTC) to oversee the bailout and disposition of failed savings and loans institutions. At a cost of hundreds of billions of dollars, the RTC cleaned up the industry and then was dissolved in 1998.

Because of the crisis in the 1980s, especially with savings and loan associations, and because of continued financial difficulties of some banking institutions, critics have suggested that the insurance plans themselves may have contributed to some of these problems.

How can insurance designed to protect depositors be a problem? Currently, depositors can have separate accounts insured up to $250,000. With confidence that an account insured by the FDIC will be paid in case of institution failure, many individuals have placed money in risky or shaky financial institutions. Evidence suggests that weak savings and loans often offered higher rates of interest to attract depositors. Even with rumors of S&Ls’ financial difficulties, depositors were attracted by the higher interest rates. When the weak savings and loan institutions collapsed, the depositors were repaid.

In some cases, financially strong banks are protesting that the system rewards inept or imprudent banks. Those institutions that charted a more conservative course by paying lower interest rates or by being more selective in granting loans feel that bailing out some institutions is rewarding poor management decisions. Likewise, the argument can be made that depositors who stayed with more conservative banks are actually paying for the depositors who opted for higher returns with risky banks.