The financial crisis of 2008 has caused economists to reexamine the forces that stabilize (or destabilize) the financial system in the United States and around the world. Despite much debate, there remains serious disagreement as to the root causes of the crisis and hence to the best solutions for preventing future crises. Some studies claim the crisis was caused by deregulation in the financial sector (Crotty 2009; Bhide 2011), but the quantity and complexity of financial regulations had in fact increased significantly in the decades leading up to the crisis. Other studies, by contrast, argue that poor or misguided financial regulations were themselves a major cause of the crisis (Calomiris 2009; J. Friedman 2011). The form of potentially misguided financial regulation that we focus on here is government-administered deposit insurance, managed in the United States by the Federal Deposit Insurance Corporation (FDIC). This paper discusses the evidence from U.S. history and around the world that government deposit insurance leads to more bank failures and financial crises. We consider changes that might be made to the FDIC and the U.S. deposit insurance system to help stabilize the banking system and prevent future financial crises.
Many people are unaware that deposit insurance can reduce stability in the banking system. The literature in support of deposit insurance is based largely on theoretical models (e.g., Diamond and Dybvig 1983). (1) This line of research assumes banking is inherently unstable and that the government has special powers or privileges that enable it to prevent bank runs when private actors cannot. Deposit insurance is often modeled as an idealized and actuarially fair system that prevents crises without creating any harm to the economy. (2) More realistic models, however, include the disadvantages of deposit insurance, such as the problems of moral hazard and increased risk taking that occur when depositors' funds are guaranteed because the depositors no longer have strong incentives to monitor banks' risk-taking activities. From theory alone, it is unclear whether government deposit insurance should be expected to reduce the number of bank failures by preventing runs or to increase the number of bank failures because of moral hazard. We must therefore turn to the empirical studies that analyze the effects of deposit insurance in the real world.
Despite the common perception among both laymen and economists that deposit insurance helps stabilize the banking system, most empirical studies find that deposit insurance decreases stability. After briefly discussing the history of the FDIC, we analyze two strands of the empirical literature. First, international studies of deposit insurance systems around the world indicate that countries with higher levels of deposit insurance coverage and countries with more government involvement in the administration of deposit insurance tend to have higher numbers of bank failures and more frequent financial crises. Second, studies of the banking system in the United States prior to the establishment of the FDIC show similar results. Many U.S. states established their own deposit insurance systems through public or private means, especially prior to the nationalization of the U.S. banking system during the Civil War. Other states evolved competing private systems of insurance or functioned efficiently with no deposit insurance system at all. These private, pre-FDIC systems were effective at regulating the financial system, bailing out troubled banks, and preventing contagious bank runs that could lead to financial crises. Overall, the evidence indicates that reducing the FDIC's role in deposit insurance is likely to increase stability in the U.S. banking system.
Given this evidence, we next consider three potential changes to the FDIC system. First, the administrative side of deposit insurance can be improved by replacing the FDIC with a privately managed organization, as is the case in most developed nations. Second, the mandated level of FDIC coverage might be reduced, allowing private suppliers to make up the difference. Third, the system could be privatized entirely by eliminating mandated coverage and allowing insurance to be provided privately rather than through the FDIC. Absent the FDIC, private institutions similar to those that existed before the FDIC would likely evolve to provide deposit insurance, consumer protection, and banking stability. These changes would reduce the problems with government deposit insurance, especially moral hazard, and would help stabilize the U.S. banking system.
Studies of Deposit Insurance
Deposit insurance creates two conflicting forces that influence bank failures. On one hand, it removes the incentive for depositors to run on the bank, so banks are less likely to fail from nonfundamental causes. On the other hand, it creates moral hazard. Because banks are not monitored by depositors, they invest in riskier assets and are more likely to fail from fundamental causes. It is impossible to know in theory which of these effects will be greater, so we must look to the empirical literature--including literature on the history of the FDIC and international studies comparing deposit insurance systems around the world and deposit insurance in the United States prior to the FDIC--to find out whether deposit insurance makes banks more or less likely to fail in the real world. The evidence strongly indicates that systems with higher levels of deposit insurance and more government involvement are subject to higher instances of bank failures and financial crises.
The FDIC was established to stabilize the banking system and protect individual depositors in response to the banking panics of the early 1930s that largely contributed to the Great Depression in the United States (FDIC 1998, 20-27; Bradley 2000, 1-4). Although the FDIC is commonly credited with stemming bank runs, (3) deposit insurance has also increased the number of bank failures due to moral hazard. Many studies find that FDIC insurance played an important role in contributing to the 2008 financial crisis, and the Federal Savings and Loan Insurance Corporation (FSLIC) that is now a part of the FDIC played the same role in the savings and loan (S&L) crisis of the 1980s.
A series of bank failures during the early years of the Great Depression paved the way for the adoption of federal deposit insurance. (4) In 1931, the rate of bank failures and losses to depositors skyrocketed as the Federal Reserve failed to abate the shortage of liquidity in the banking system (Friedman and Schwartz 1963, 676; FDIC 1998, 21; Bernanke 2004). In January 1932, a federal lending agency called the Reconstruction Finance Corporation was created, and by the end of the year it had "authorized almost $900 million in loans to assist over 4,000 banks striving to remain open" (FDIC 1998, 22). Nevertheless, deteriorating conditions led to a nationwide bank holiday, and after much deliberation and debate the FDIC was established in the Banking Act of 1933 (FDIC 1998, 27). The act provided the Temporary Deposit Insurance Fund, which began coverage on January 1, 1934, and a permanent plan that was to take effect on July 1, 1934, but was later delayed to July 1, 1935 (FDIC 1998, 30). There was strong opposition to federal deposit insurance, even by President Franklin Roosevelt and others in the administration, (5) but sentiments began to shift in 1934 as the rate of bank failures declined (FDIC 1998, 31). The Temporary Deposit Insurance Fund was at the time seen as a major contributing factor in stopping bank failures, so the opposition to it mostly faded. Thus, the perception that FDIC insurance stabilizes the banking system has been perpetuated to the present day despite much evidence to the contrary.
The FDIC's scope, coverage, and costs have greatly expanded over time and no longer resemble its original purpose. The initial coverage level of $2,500 per depositor was increased to $5,000 within just six months of adoption (Bradley 2000, 9). Since permanent FDIC insurance took effect in 1935, the maximum coverage amount has been increased six times, most recently in 2008, when it was increased to $250,000, where it stands today. "Since its inception, the real scope of federal deposit insurance ... has increased by roughly 514 percent," outpacing growth in total deposits and income per capita (Hogan and Luther 2014, 153-54).
Despite the early perception that the FDIC reduced the frequency of bank failures, most evidence suggests it actually did the opposite. As Charles Calomiris and Stephen Haber point out, "Although the civics textbooks used by just about every American high school portray deposit insurance as a necessary step to save the banking system, all the evidence indicates otherwise: it was a product of lobbying by unit bankers who wanted to stifle the growth of branch banking" (2014, 190). (6) Empirical studies of FDIC insurance suggest that the effects of moral hazard are present and possibly strong. Richard Cebula and Willie Belton find that federal deposit insurance coverage increased the rate of commercial bank failures (1997, 281), and Alden Shiers indicates that "higher levels of deposit insurance are positively and significantly associated with increased riskiness of commercial banks" (1994, 359). Ira Saltz examines the link between the level of FDIC coverage and the frequency rate of bank failures and finds "strong evidence of a cointegrating relationship between the bank failure rate and the extent of central government-provided deposit insurance" (1997a, 71), indicating that "federal deposit insurance very likely induced bank failures" (1997b, 3).
Evidence also indicates federal deposit insurance was a major cause of the S&L crisis of the 1980s. At the time of the crisis, deposit insurance for these institutions was provided through the FSLIC. Like the...