What is the necessity for the FDIC in the banking system?


by lugita15
Tags: banking, fdic, necessity
lugita15
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#19
Sep20-13, 12:10 PM
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Quote Quote by MrAnchovy View Post
What use to the bank's shareholders is insurance that pays out to the bank's customers in the event that the shares become worthless?
Well, surely the shareholders have an interest in the bank continuing to stay in business, so that their shares continue to have value and grow. And also, buying deposit insurance would make depositors more likely to keep their money there in the first place.
MrAnchovy
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#20
Sep20-13, 12:16 PM
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Quote Quote by lugita15 View Post
I did some searching, and it looks like Switzerland has a private deposit insurance system, although the government requires that banks buy deposit insurance.
This (and similar schemes in other countries that I am aware of) is not like a normal policy provided by an insurer in return for payment of a premium. Essentially it is a club where every member guarantees that if any member fails, the other members will bail them out. There is therefore no material up-front cost to the members.
MrAnchovy
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#21
Sep20-13, 12:27 PM
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Quote Quote by lugita15 View Post
Well, surely the shareholders have an interest in the bank continuing to stay in business, so that their shares continue to have value and grow.
But the insurance would only pay out when the bank has gone out of business.

Quote Quote by lugita15 View Post
And also, buying deposit insurance would make depositors more likely to keep their money there in the first place.
Two problems with this: (i) if you want a safe investment at a low rate of interest you invest in treausury bills; the cost of insurance would reduce interest rates below t-bills (ii) big insurance companies are no more financially stable than big banks so the insurance would be worthless
lugita15
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#22
Sep20-13, 12:36 PM
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Quote Quote by MrAnchovy View Post
But the insurance would only pay out when the bank has gone out of business.
What about an insurance policy that gives the bank money whenever its depositors' demands exceed its reserves on hand?

Two problems with this: (i) if you want a safe investment at a low rate of interest you invest in treausury bills; the cost of insurance would reduce interest rates below t-bills
Why is it that the insurance premiums would necessarily push the interest rates below that of Treasury securities? And if that's true, then banking with actuarially fair insurance premiums is unprofitable, and that means that banking in the absence of insurance is unprofitable given the expected value of the risk. So why did banks even exist before the FDIC?

(ii) big insurance companies are no more financially stable than big banks so the insurance would be worthless
But presumably there will be occasions in which a bank has a run but the insurance company is still solvent, so it does provide some stability.
SteamKing
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#23
Sep20-13, 04:51 PM
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Banks existed before the FDIC so that people wouldn't have to lug around their money with them at all times and provide constant vigilance against thieves. As you can imagine, having to build a castle or other such fortress to protect your stash gets mighty expensive. If you want to go somewhere, you either have to take your money with you or worry that your castle will get sacked in you absence. Even for the holder of a modest stake, a bank provides more security than a shoe box.

Once banks were established, and they accumulated the savings of a diverse clientele, it was natural for the banks to loan money and charge interest to the borrowers. The bank got to use the interest to defray its overhead and the local economy got a boost in the form of investment which created new goods and services.

Banks also provide a means whereby through money orders, checks, etc., money physically does not have to be present at each exchange, like when you make a large purchase or settle a debt or you need to transfer funds over a large distance. In fact, before the US Civil War, local banks printed and distributed paper notes which acted as a form of currency. Now, the area where this form of currency might be accepted was limited, but there was no national form of currency except for coinage issued by the US Mint. When the civil war broke out, there was a need for more money to be in circulation than could be filled by using coins made of precious metals. The Lincoln administration issued the first national paper currency, which were called 'greenbacks' because of the green ink used to print the bills. As was a lot of things, the greenbacks were supposed to be a temporary fix to a shortage of money in circulation caused by the war. After the war ended, US Notes continued in circulation, whereby the holder of the note could redeem it with the Treasury for the amount of gold or silver equal to the face value of the note. When the Federal Reserve was created in 1913, the US began to issue federal reserve notes, which circulated along with gold and silver coins as legal tender. In 1933, all gold coins in circulation were recalled by the Treasury Department after the private possession of gold coins was outlawed in the US.

For a history of paper currency in the US, see:
http://en.wikipedia.org/wiki/Federal_Reserve_Notes
http://en.wikipedia.org/wiki/United_States_Note

For more information about banks:

http://en.wikipedia.org/wiki/Bank
lugita15
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#24
Sep20-13, 04:58 PM
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SteamKing, I'm fully aware of the function of banks and the role they've played in our monetary system. What I was asking was, if banking would be unprofitable if banks had to pay actuarially fair premiums for deposit insurance, then doesn't that mean that banking would be unprofitable in the absence of deposit insurance, given the expected value of the risk? And wouldn't that mean that there would be no incentive for anyone to open a bank?
MrAnchovy
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#25
Sep20-13, 06:02 PM
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Quote Quote by lugita15 View Post
What about an insurance policy that gives the bank money whenever its depositors' demands exceed its reserves on hand?
  1. As I said in my first post, insurance is there to compensate the insured person for a loss: the bank doesn't suffer a loss when depositors withdraw money.
  2. If a bank had such an indemnity in place, what incentive would there be to avoid behaviour that could lead to a run?

Quote Quote by lugita15 View Post
Why is it that the insurance premiums would necessarily push the interest rates below that of Treasury securities?
Because the principal reason a bank deposit pays out a higher rate than a T-bill is the risk premium. Given that an insurer can take on this risk by investing in the bank's securities directly (or a derivative therof) they are hardly likely to indemnify a depositor against the same risk for a lower return.

Quote Quote by lugita15 View Post
And if that's true, then banking with actuarially fair insurance premiums is unprofitable, and that means that banking in the absence of insurance is unprofitable given the expected value of the risk. So why did banks even exist before the FDIC?
No, from the bank's point of view it is always profitable - they make their profit when times are good and (unprotected) depositors lose their deposits when the bank collapses. From the depositor's point of view, in theory and over the long term, the risk premium on deposit interest rates over T-bills should exceed the losses from bank insolvency.

Quote Quote by lugita15 View Post
So why did banks even exist before the FDIC?
Why did houses exist before fire insurance?

Quote Quote by lugita15 View Post
But presumably there will be occasions in which a bank has a run but the insurance company is still solvent, so it does provide some stability.
Why would anyone pay for insurance that may only pay out "on occasions"?
MrAnchovy
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#26
Sep20-13, 06:33 PM
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Note that the lack of understanding and consequent undervaluing of a similar risk, namely Credit Default Swaps (where a bank pays a premium to transfer the risk of lending money to people who cannot pay it back) is what upset the apple cart in the first place.

Here is an interesting article analysing some of the issues raised by CDS.
SteamKing
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#27
Sep20-13, 07:07 PM
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What would be an actuarially fair premium for bank deposit insurance?

Are you claiming that the FDIC's deposit insurance premiums to member banks aren't based on the potential risks faced by the banks?

The FDIC has some info on insurance premiums:
http://www.fdic.gov/deposit/insurance/

N.B.: the FDIC premiums have risen recently not only to replenish losses incurred by events after 2008, but also to anticipate future problems.

Everyone takes it for granted that insurance for whatever losses will always be available. This is not so. Even home owners insurance, once typically very cheap and covering most perils (except flooding) has become hard to acquire in certain areas of the country, and what is available has risen steeply in cost while reducing coverage at the same time. Wind coverage is almost unobtainable except for state run risk pools. Expect the same to happen to already expensive medical insurance after the ACA gets up and running.

The insurance companies are not stupid. If they can't turn a profit in a certain market, they will shift their attention to other areas of the economy in which to invest their funds.
lugita15
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#28
Sep21-13, 03:16 PM
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Quote Quote by MrAnchovy View Post
As I said in my first post, insurance is there to compensate the insured person for a loss: the bank doesn't suffer a loss when depositors withdraw money.
Yes, the bank doesn't suffer a loss if depositors withdraw their money under normal circumstances. But a bank definitely suffers a loss if it has to go out of business due to not having enough reserves on hand to pay the depositors' demands. So an insurance policy that gave the bank money when it doesn't have enough money to pay depositors would certainly benefit the bank at the time of a run. And also, the fact that a bank has such a policy would give depositors greater confidence, so the bank would get more deposits, which would certainly benefit it.
If a bank had such an indemnity in place, what incentive would there be to avoid behaviour that could lead to a run?
Well, the insurance company would presumably adjust its insurance premium based on how risky the bank's activities are, similarly to how health insurance companies give discounts to non-smokers and car insurance companies give discounts to safe drivers. So the bank has an incentive to not engage in practices that are too risky.
Because the principal reason a bank deposit pays out a higher rate than a T-bill is the risk premium.
Well, presumably an insurance company is less stable than the government, so there would still be a risk premium because the insurance company could fail, just less of a risk premium.

But this raises a question: why is there a risk premium on bank deposits nowadays, when there's no risk (at least up to the first hundred thousand dollars) due to the FDIC? And why is it, that when the government guaranteed money market funds in the crisis of 2008, that the rate on money markets only went down to the rate on bank deposits, rather than all the way down to the rate on Treasury securities?
No, from the bank's point of view it is always profitable - they make their profit when times are good and (unprotected) depositors lose their deposits when the bank collapses.
Well, presumably banks don't want to collapse.
Why did houses exist before fire insurance?
Because the premiums required to purchase fire insurance would not make it unprofitable to buy a house, which implies that the expected value of the risk of fire is not so great as to make it unprofitable to buy a house without fire insurance.

But in this case, if you're telling me that if banks had to buy private deposit insurance in the days before the FDIC, they would have to reduce their interest rate from x% to a rate (x-y)% which is lower than the rate on Treasury securities, doesn't that mean that in the absence of deposit insurance, the expected value of the rate of return for a depositor is also (x-y)%, in which case why would depositors put their money in banks at all before the FDIC?
Why would anyone pay for insurance that may only pay out "on occasions"?
I didn't mean "on occasions" as in rarely. I meant, that although there might be some circumstances in which a bank run coincides with the insurance company going insolvent, presumably many if not most bank runs do not involve an insurance company collapsing (other than financial crises like 2008.)
lugita15
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#29
Sep21-13, 03:17 PM
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Quote Quote by MrAnchovy View Post
Note that the lack of understanding and consequent undervaluing of a similar risk, namely Credit Default Swaps (where a bank pays a premium to transfer the risk of lending money to people who cannot pay it back) is what upset the apple cart in the first place.
Yes, I mentioned that in the OP.
lugita15
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#30
Sep21-13, 03:25 PM
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Quote Quote by SteamKing View Post
What would be an actuarially fair premium for bank deposit insurance?

Are you claiming that the FDIC's deposit insurance premiums to member banks aren't based on the potential risks faced by the banks?
Well, I'm claiming that the FDIC may be charging the banks subsidized premiums. Multiple people on this thread have said that banking would not have been profitable if banks had to buy private deposit insurance. Since banking is profitable right now, that implies that the FDIC is charging banks less than the free market would charge them, i.e. the FDIC is not charging actuarially fair premiums.

The FDIC has some info on insurance premiums:
http://www.fdic.gov/deposit/insurance/

N.B.: the FDIC premiums have risen recently not only to replenish losses incurred by events after 2008, but also to anticipate future problems.
Well, both things could be true: the FDIC could be charging enough of a premium so that it won't be out of money when there are bank runs, and yet it may not be charging as much as it would charge if it were a private company concerned only with profit maximization.
SteamKing
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#31
Sep21-13, 04:46 PM
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The FDIC is a government chartered institution. If it gets into difficulty, as the FSLIC did in the 1980s, it can turn to the Federal Government for a bailout. If a private deposit insurance company got hit with too many claims, it would be obliged to enter bankruptcy, and the depositors would probably be wiped out.

As to whether banking would be unprofitable if they had to pay premiums based on actuarially-determined premiums, who knows? Such an animal doesn't exist. However, if it did, the price of bank loans would probably rise to cover any increased overhead which the banks must defray, so you would see more fees and higher interest rates on mortgages and consumer loans.

It's analogous to the banks being able to avail themselves of low cost (maybe no cost) loans at the Federal Reserve Discount Window when they get into short-term cash crunches. The government is exercising its power to provide stability to the banking system in economically troubled times so that problems at a few institutions do not cascade throughout the financial system and cause further problems.

The federal government provides flood insurance to homeowners who would otherwise not be able to find any insurance, or who would be unable to afford the premiums on what private insurance which might be offered. Is federal flood insurance offered with premiums which are actuarially determined? Of course not. Has that prevented private insurance from offering flood insurance? Quite probably, but it is doubtful that private flood insurance would be affordable in coastal areas, even if offered.
MrAnchovy
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#32
Sep21-13, 06:14 PM
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@lugita I'm not going to restate the reasons why things are the way they are, but I will pick up on a couple of things you have said...

Quote Quote by lugita15 View Post
Yes, the bank doesn't suffer a loss if depositors withdraw their money under normal circumstances. But a bank definitely suffers a loss if it has to go out of business due to not having enough reserves on hand to pay the depositors' demands.
That may be what you call a loss, but it is not what the legal framework that underlies insurance calls a (insurable) loss.

Quote Quote by lugita15 View Post
But this raises a question: why is there a risk premium on bank deposits nowadays, when there's no risk (at least up to the first hundred thousand dollars) due to the FDIC?
Risk doesn't just mean that you might lose your money, it also includes volatility (e.g. the risk that deposit interest rates go down when you could have locked in to a higher fixed rate on a T-bill) and opportunity risk (e.g. the risk that deposit rates go up when you have locked into a term deposit). Currently the risk premium available in the market is in fact near enough zero but this is not in general due to deposit protection schemes, (in the US and UK) it is mainly that banks don't need depositors' money because they have more of the central bank's money than they can find viable lending opportunity for due to quantitive easing.

Quote Quote by lugita15 View Post
Because the premiums required to purchase fire insurance would not make it unprofitable to buy a house, which implies that the expected value of the risk of fire is not so great as to make it unprofitable to buy a house without fire insurance.
Er no, houses existed because people needed them to live in. Similarly banks exist because people and organisations need somewhere to keep their money that facilitates transactions between them.

Quote Quote by lugita15 View Post
But in this case, if you're telling me that if banks had to buy private deposit insurance in the days before the FDIC, they would have to reduce their interest rate from x% to a rate (x-y)% which is lower than the rate on Treasury securities, doesn't that mean that in the absence of deposit insurance, the expected value of the rate of return for a depositor is also (x-y)%, in which case why would depositors put their money in banks at all before the FDIC?
Well even assuming that what you say is theoretically valid, there are two practical reasons why: firstly because they have to do something with their money (see above) and secondly because the expected value of a return is not in general a useful way of measuring its worth to you because of the skewed distribution of outcomes: consider two investments, one with a certain return after 12 months of 4% (expected value 4%) and one with a 98% probability of a 6% return and a 2% probability of a -100% return (expected value 3.9%). The investment with the lower expected value will be preferred by all except a risk averse investor.

Quote Quote by lugita15 View Post
Multiple people on this thread have said that banking would not have been profitable if banks had to buy private deposit insurance.
I don't think anyone (except you) has said that. I have said that banks would not be able to offer attractive rates to depositors if those rates had to pay for a premium-backed deposit insurance scheme.

Finally (I don't plan to post again on this thread), take note of what SteamKing says. You have an unrealistic view of the value of market-based insurance: if there was a price at which a free market insurer was able to supply a product that depositors were willing to pay for, the product would exist. Even if you believe theoretically that such a product should exist, the empirical evidence points the other way.
Hornbein
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#33
Sep24-13, 10:28 PM
P: 72
Quote Quote by lugita15 View Post

My question is, in the absence of the FDIC, why wouldn't banks just obtain private deposit insurance?
I have two answers.

Quite often banks collapse due to deliberate fraud. Insurance payments would decrease the take. Also, no private insurance company is going to pay in such a case. It would be like paying the life insurance benefits for a suicide. In other cases, it is difficult to tell whether the fraud was deliberate: depositors might have to wait decades for a settlement. It may be that there is no clear answer to this question. Then do the depositors get, say, 50%? What a mess.

The second answer is to look at AIG, which sold insurance for all sorts of financial instruments. Its bankruptcy was a big factor in the 2008 collapse. So I'd say that no private company has the power to survive such a collapse, which is when the insurance is most needed. A private company could also be a fraud, so it doesn't really solve the problem of investor confidence.


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