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

[SteamKing]

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.

 

[pbuk]

@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...

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.

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 into 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.

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.

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.

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]

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.