Dismiss Notice
Join Physics Forums Today!
The friendliest, high quality science and math community on the planet! Everyone who loves science is here!

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

  1. Sep 19, 2013 #1
    A bank's basic function is to "borrow short and lend long". In other words, it borrows money from depositors over the short term, promising to repay it on demand, while it lends most of that money out over the long term to borrowers, for instance in the form of 30-year mortgages. This difference between these time frames, known as maturity mismatch, leads to systematic problems for banking. It makes banks vulnerable to crises, because if all the depositors show up one day asking for their money, the bank can't give it to them, because it's been lent out to borrowers, so the bank becomes instantly insolvent, even if it had no financial troubles before the depositors were worried about the bank's solvency.

    Indeed, this used to happen frequently in the 1800's and early 1900's, most prominently in the Great Depression, until the FDIC came about. The FDIC makes all the banks pay a premium, and in exchange, whenever there's a run on a bank, the FDIC gives the bank money so that it can meet all its depositors' demands (at least up to a cap, like a hundred thousand dollars per account).

    My question is, in the absence of the FDIC, why wouldn't banks just obtain private deposit insurance? Whenever people have significant risks, even if they're small, they tend to buy insurance. You don't have a very great risk of dying tomorrow, or having a car accident, or having a flood in your house, but still you buy insurance just in case. Companies of all kinds do the same: stores buy liability insurance, fire insurance, etc. So why wouldn't banks insure their risks similarly?

    And it's not like banks don't buy private insurance already. For instance, when they lend out money, they buy insurance in case the borrower defaults on a loan - it's called a credit default swap. (Those were partially responsible for the financial crisis of 2008.) So what reason would they have for not buying insurance in case their depositors' demands exceed their reserves?

    Is the problem that the premiums they would have to pay on the free market would be too high to make banking profitable anymore? If that's the case, then does that mean that the FDIC is not charging actuarially fair premiums to banks right now?

    Any help would be greatly appreciated.

    Thank You in Advance.
  2. jcsd
  3. Sep 20, 2013 #2


    User Avatar
    Science Advisor
    Gold Member

    FDIC prevents "runs on the bank" ... which occur when depositors lose faith in their local bank.

    This was quite common during the Great Depression prior to the creation of modern banking laws, including the FDIC.
  4. Sep 20, 2013 #3
    I mentioned all that in the OP. But my question was, why wouldn't the banks just buy private deposit insurance on their own?
  5. Sep 20, 2013 #4


    User Avatar
    Science Advisor
    Gold Member

    My answer refers to the history ... you have to look into the history of a bill if you wish to understand it.

    Otherwise you are asking me to hypothecate based on your ideas.
  6. Sep 20, 2013 #5
    OK, let me put it this way then: what is the reason that banks *didn't* get private deposit insurance before the FDIC, when other industries buy insurance all the time to cover their risks, and banks themselves get insurance to cover other risks, like loan default?
  7. Sep 20, 2013 #6


    User Avatar
    Gold Member

    Are you mixing up who is taking the risk with your money when you deposit it into a bank.

    You mention banks aquire insurance for loans to a borrower.

    When you deposit your savings into a bank, you are actually loaning your money to them and receiving a rate of return for that action. If you feel the bank may default on your loan to them, then go out and buy some insurance to cover your perceived risk and potential loss.
  8. Sep 20, 2013 #7


    User Avatar
    Gold Member

    Your question is quite a reasonable one. I think the answer is that historically, at the time of the creation of the FDIC, banks were viewed (correctly) as very unstable and private insurance would have been onerous. Yes, this means that the FDIC in some sense doesn't charge fair market value for the insurance it provides, but the idea was always that by virtue of having the full faith and credit of the United States behind it, it wouldn't NEED to actually bail out very many banks because its existence would eliminate bank runs.

    This benefits the economy so greatly that the federal government actually "turns a profit" on the whole deal because of the vastly increased tax revenues that accrue due to a stable financial environment (OK, yes, you have to now take that with a grain of salt after 2008, but bank runs weren't the problem there.)

    Could private insurance take over at this point? Maybe, but who wants to fix a system that isn't broken?
  9. Sep 20, 2013 #8
    But isn't it also in the incentive of banks to make sure it pays its depositors, to prevent insolvency, bank runs, and bankruptcy?
  10. Sep 20, 2013 #9
    I think the reason that deposit insurance isn't undertaken by the private sector is because they couldn't be trusted to pay out in a crisis. Insurance companies invest collected premiums. If their was a financial crisis they would have to withdraw their money from the system by selling securities or pulling money out of banks, to the pay out depositors. This would only exacerbate a crisis.

    Also the sheer scale of the loss is unfavorable to insurance, which prefers claims to be small and customers to be large and diverse. Hence why you see insurance often evading coverage, for such things as earthquakes and flooding.
  11. Sep 20, 2013 #10
    If it would have made banking an unprofitable enterprise to pay the premiums to insure the risk, doesn't that mean that banking back then was unprofitable once you took into account the expected value of the risk? So were people back then acting foolishly by opening banks in the first place?
    Wouldn't that be equally true of a well-capitalized insurance company? Or is the issue that no insurance company can ever be as well-capitalized as the US government?
    Well, this isn't just a matter of existing institutions. Now the shadow banking system - things like repo - exhibit the same behavior of borrowing short and lending long, and they have the same vulnerability to crises as we saw in 2008, so the Dodd-Frank bill has tried to impose an FDIC-like regime on them. But I have the same question for that - why wouldn't the players in the repo market have gotten the equivalent of insurance on their own, and if insurance makes them unprofitable given the expected value of the risk, why would the repo market exist at all?
  12. Sep 20, 2013 #11
    Well, maybe private deposit insurance may not be able to solve a major financial crisis, but about at least for run-of-the-mill bank runs?

    What does the insurance company care about the size of the loss, as long as it charges a big enough premium?
  13. Sep 20, 2013 #12
    These are all relevant points, however there are two "show stoppers" that prevent this.

    Firstly, the essence of insurance is that it compensates the insured person for a financial loss suffered when a specified peril occurs. When a bank suffers a run, people withdraw money that is owed to them by the bank - this is not a financial loss to the bank and is therefore not insurable.

    So instead there is a system in each state with a mature retail banking sector by which the state ensures that individuals are protected from the loss that they may suffer if a bank becomes insolvent. But this doesn't mean that the state gives the bank money so that it can pay its depositors like an insurance company would; what generally happens is that the state steps in and takes control of the bank, either arranging for it to be sold to another bank that has sufficient capital to resource the combined operations, breaking it up by selling off the assets to other banks and using the proceeds to pay off the depositors, or injecting capital so that the bank can continue to operate and the state becomes the owner. A number of examples of each of these three can be found in recent years (there is also one example, Lehman Brothers, of the alternative which is to let the bank fail and deal with the consequences which is another topic entirely; note that relatively little of Lehman's liabilities to US depositors were protected).

    This is not the sort of thing that an insurance company can do; only two entities are capable of taking on all the assets and liabilities of an insolvent major bank without threatening their own financial stability: the state and the central bank. There are very good reasons why central banks should not participate in commercial and retail banking activities, and so that leaves the state.
  14. Sep 20, 2013 #13


    User Avatar
    Gold Member

    Federal deposit Insurance is there to promote confidence in the banking system and money supply and thus prevent bank runs.

    When you deposit in the bank, it become their money, you have loaned it to them - you possess a paper ( your deposit slip or whatnot of the transaction as proof ). It is in your best interest to not call the whole loan ( in concert with all other depositors ) to cause the bank to cease operation and close its doors.

    The bank still has assets in the form of the loans it has made to borrowers, so it is not firstly evident that it will become insolvent and have to declare bancruptcy.

    Although, simply put, when a bank run does occur due to non-confidence in the money supply, a circle of defaults occurs. The money supply quickly becomes scarce and no one, or very few, can make the obligation for a payment on a debt. Everyone looses.

    The reason you can use a fin or a twenty or fifty bank note to pay for goods and services is that you and everyone else has confidence in that note as being worth the value printed on it, and that all members using money have confidence in the banks and government issuing that note.

    Even with a type of insurance as you propose, non-confidence in that note would make the insurance basically of no value.
  15. Sep 20, 2013 #14
    Oops, I missed the "easy" option which is that the central bank can step in and lend the bank the cash to pay out to its depositors. This only works while the central bank believes that the problem is just one of timing (e.g. Northern Rock in September 2007); if/when it becomes clear that the bank's assets are not in fact worth enough to restore its capital position or find a buyer that can, the state steps in (February 2008).
  16. Sep 20, 2013 #15


    User Avatar

    Staff: Mentor

    1. Who sells such insurance?
    2. Who could afford to?
  17. Sep 20, 2013 #16


    User Avatar
    Staff Emeritus
    Science Advisor
    Homework Helper

    In the case of the FDIC, the Federal Government acts as the insurer of last resort. It nationalizes the risk that a single bank or banks might go insolvent through a run on the bank, malfeasance, natural disaster, whatever.

    Private insurers may not have sufficient assets to pay out claims after a bank fails. Some banks are very large institutions, financially speaking, and any private insurer, to be credible, would have to have available large financial resources to cover potential claims. Also, in times where economic factors may increase the likelihood of bank failure, premiums would rise to the point where it became uneconomical to keep the insurance, or insurance might not be available at any price. Try getting insurance on your home or car when there is a tornado coming down the road.

    This is not to say that the system can prevent all types of financial mishaps. The recent economic crisis drove FannyMae and FreddyMac to the wall, where a large bailout was necessary to keep these institutions afloat. Fanny and Freddy guaranteed mortgages on homes, and when large numbers of mortgages went into default, there were not enough funds to make lenders whole.

    A similar situation occurred in the 1980s with savings and loans. The FSLIC was an agency similar to the FDIC in that it offered deposit insurance to customers of member savings and loan associations. Since S&Ls primarily served customers by using their deposits for home loans, these institutions functioned rather quietly while default rates were low and S&Ls were strictly regulated on the types of loans they could make.

    After the rules were relaxed in the early 1980s, S&Ls expanded from the residential market into loans on various types of commercial developments, like condos and shopping centers and malls. Deposit insurance was increased at the same time to $100k per depositor. There was a frenzy to make large loans on very speculative, or even outright fraudulent, projects to such an extent that S&Ls began to fail, and the FSLIC had to step in to protect depositors and reorganize or sell the failed S&L. The problem grew to such an extent that the FSLIC ran out of funds to do its job in the late 1980s.

    To fix this problem, the FSLIC was abolished and its financial duties were absorbed by the FDIC. The assets which remained from the failed institutions were taken over by a new entity called the Resolution Trust Corp. (RTC), which was charged with recovering what funds it could. This whole debacle should have served as a warning to prevent the larger excesses which occurred in 2008.
  18. Sep 20, 2013 #17
    I did some searching, and it looks like Switzerland has a private deposit insurance system, although the government requires that banks buy deposit insurance. That raises the question, though, of why the requirement is needed: why wouldn't the banks do it voluntarily?
  19. Sep 20, 2013 #18
    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?
  20. Sep 20, 2013 #19
    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.
  21. Sep 20, 2013 #20
    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.
Share this great discussion with others via Reddit, Google+, Twitter, or Facebook