Explicit and Implicit Costs of Government-Provided Deposit Insurance

Abstract

The Diamond–Dybvig model is often cited as a theoretical justification for government-provided deposit insurance. Guaranteeing bank deposits removes the temptation for individual depositors to run on the bank and thereby precludes the need to ever use the deposit insurance. Hence, deposit insurance provides a costless solution to the threat of bank runs. In practice, however, government-provided deposit insurance is not a costless solution as it is frequently invoked to cover the losses of failed banks. We maintain that potential alternatives to government deposit insurance should be compared to the current system rather than to a theoretically optimal system of insurance. Focusing on the FDIC, we consider the differences between deposit insurance in theory and practice, review how the explicit cost of providing deposit insurance has changed over time, and consider implicit costs from taxpayer backing and suboptimal assessment rates.