In testimony before Congress in 2003, then Federal Reserve Chairman Alan Greenspan said that deposit insurance has prevented bank runs like those in the 1930s that could have undermined the banking system and the nation’s financial system. He noted, however, that the prevailing levels of deposit insurance increased risk-taking at insured depository institutions to levels that could endanger the financial system. The upshot is that deposit insurance increases financial stability in the short run but increases risk-taking by depository institutions to a degree that could create problems for the financial system.

Another issue associated with deposit insurance is that it makes it possible for depository institutions to attract more funds, at lower interest rates, than would be the case without insurance. In effect, it allows them to make more risky loans without losing some or all their deposits. The net effect is that resources are misallocated because the link between risks and rewards is removed for depository institutions but not for other financial services providers.

Chairman Greenspan argued that the risk-based premium system for deposit insurance be changed. Currently, the FDIC imposes higher deposit insurance premiums on depository institutions that engage in riskier loans and investments. There is a loophole in the law. Well-capitalized, highly rated depository institutions do not have to pay any premiums when the FDIC’s reserves are greater than 1.25 percent of insured deposits. Chairman Greenspan also noted that 91 percent of depository institutions are not required to pay deposit insurance premiums. Many of these institutions have never paid premiums.

Chairman Greenspan recommended that the risk-based pricing system be reformed to require every insured depository institution to pay deposit insurance premiums. The exemptions for well-capitalized firms would be eliminated. Each depository institution would then pay deposit insurance premiums no matter how well rated it may be or how well capitalized it is.

How would Chairman Greenspan’s proposal reduce misallocation of resources mentioned in his testimony?