The Financial Hazards and Risks Entailed in Extending Unlimited Federal Guarantees for Deposits in Transaction Accounts

Abstract

In the aftermath of a financial crisis, policymakers often must determine how best to trade off future security from a similar crisis and future moral hazard. The more the government pledges to protect the value of the assets of financial institutions in a crisis, the greater the risks that those institution may take in search of higher profits. Since the 2008-2009 financial meltdown, U.S. policymakers have faced this trade-off in various forms. One example is the debate over making permanent the “Transaction Account Guarantee” (TAG) program. This program was created in October 2008 to temporarily guarantee deposits held in non-interest-bearing transaction accounts above the existing $250,000 limit. The higher coverage was voluntary, but 87 percent of banks and savings institutions that were part of the Federal Deposit Insurance Corporation (FDIC) system opted for increased coverage. However, once the immediate panic passed in 2009, the FDIC extended the TAG program. In 2010, the Dodd-Frank financial reform legislation replaced the temporary, voluntary TAG program with two more years of mandatory coverage for all transaction accounts without a dollar limit at all FDIC-insured institutions. This program is scheduled to expire at the end of 2012, sparking a debate over whether its unlimited guarantee should end or become permanent. This essay examines this debate and concludes that extending an unlimited transaction account guarantee would harm the stability and competitiveness of U.S. banking. Unlimited deposit insurance increases moral hazard, and the historical evidence suggests that unlimited deposit insurance increases the likelihood of banking crises. The transaction account guarantee also is unnecessary: The data show that the U.S. banking sector returned to pre-crisis levels of profitability in 2011. Claims that the guarantee is necessary to ensure a “level playing field” for small and large banks also are flawed: Since December 2008, non-TAG deposits have grown in banks of all sizes, including small institutions. Finally, extending this federal guarantee could send a negative signal to investors and the public that four years after the crisis has passed, the federal government still lack confidences in the stability of the U.S. banking system.