Deposit insurance

Since 1934, federal deposit insurance in the United States has prevented
bank runs by providing an ex ante guarantee of deposits, limited orig-
inally to $10,000 but gradually increased to $100,000. The increase in
the upper limit on the amount of insurance on each deposit was said
by a knowledgeable bureaucrat to have been reached as a compromise
between a proposal in the U.S. House of Representatives to increase the
upper limit from $40,000 to $50,000 and a proposal in the U.S. Senate
for an increase from $40,000 to $60,000. When large banks, including
the Continental Illinois Bank in 1984 and the First Republic of Dallas
in 1988, got into trouble, the FDIC deliberately removed all limits on
the amounts of deposits covered by the guarantees to halt imminent
runs and so in practice it established that banks with significant deposits
over $100,000 were ‘too big to fail’ (although the shareholders of these

banks would probably lose all of their investments in the bank’s shares;

similarly the owners of the subordinated debt of these banks might lose

their investments). The deposits of the foreign branches of these banks

had implicitly become insured even though the banks had paid deposit

insurance premiums only against their domestic deposits. Although de-

posit insurance was designed to prevent bank runs by taking care of the

‘little man,’ with a deposit initially less than $10,000, this ceiling had in

practice been raised to the sky.56

The formal $100,000 maximum on the amount of a deposit that would

be insured gave rise to ‘deposit brokers’ who would arrange for the place-

ment of larger amounts of money into deposits of $100,000 or less, en-

suring that the depositor would be fully insured. John Doe could have

an insured deposit of $100,000, his wife Mary could also have an in-

sured deposit of $100,000, and together John and Mary could have a

third insured deposit of $100,000. And the Does could follow the same

strategy with the bank across the street. The effect of this innovation

was that it provided a guarantee to wealthy individuals and hence cir-

cumvented one purpose of the ceiling. Moreover it encouraged banks to

make riskier loans since they were confident that they were protected

against runs—if these riskier loans proved profitable, the owners of the

banks would benefit and if the loans went into default, the owners would

not have to worry about bank runs (although the market value of their

own shares might decline and even become worthless).

The implosion of the bubble in Japan in the 1990s caused the value of

the loans of the banks headquartered in Tokyo and Osaka and various

regional centers to decline sharply below the value of their liabilities.

Nevertheless, there were no bank runs, the depositors were confident

that they would be made whole by the government if any of the banks

were closed.

Deposit insurance has limited both bank runs and contagion in the

runs from one troubled bank to other banks in a neighborhood. What

accounts for the reluctance to provide insurance at an earlier date?

In the long tradition of the United States, free banking, even wildcat

banking, was the rule. Anyone could start a bank, and many did. Risks

were large, banker turnover rapid. A guarantee of bankers’ deposits would

have constituted a license to speculate, if not embezzle, and would have

removed the threat of withdrawal of deposits, which was the major check

on the irresponsibility of bankers. Deposit guarantees were rejected as

conducive to bad banking as late as March 2, 1933, when the Board of

Governors of the Federal Reserve was not prepared to recommend such

a guarantee, or any other measures, on the eve of the national bank

holiday.57

The Federal Deposit Insurance Corporation had an excellent financial

record until the 1970s; the deposit insurance premiums that it collected

were much higher than the amount it paid out on bank failures. From

the beginning in 1934 through 1970, only one bank with deposits of

more than $50 million had failed, and most failures were of banks with

deposits of less than $5 million. The FDIC had in most cases arranged

for takeovers of the failed banks so that the few depositors with deposits

above the maximum insured amounts did not incur losses.

Beginning in the late 1970s the problems of the FDIC and those of

the Federal Savings and Loan Insurance Corporation (FSLIC) mounted

sharply. The FDIC rescued a considerable number of banks including

two giants, the Continental Illinois of Chicago and the First Republic

Bank of Dallas; honoring the deposit insurance guarantee cost these

agencies billions of dollars. The usual operating procedure was to close

the bank or the thrift institution when its capital had been depleted,

and then to carve a ‘good bank’ from the rescued institution while the

remaining assets of the failed institution would be retained for eventual

sale by another newly-created government agency, the Resolution Trust

Corporation (RTC). Both the insurance agencies incurred large losses in

honoring their guarantees; eventually they would obtain the funds to

pay for these losses by borrowing from the U.S. Treasury. In the early

1990s, the estimates were that the total losses to the U.S. taxpayers would

amount to $150 billion but the pick up in the growth rate of the U.S.

economy meant that the RTC received more money than anticipated

from the sale of collateral and bad loans so the losses totaled about $100

billion.58 There was some question whether a portion of this cost to the

taxpayers could be reduced by increasing the insurance premiums on

bank deposits—a suggestion resoundingly opposed by sound banks.59