The Implicit Costs of Government Deposit Insurance

Abstract

The Diamond-Dybvig (DD) model is often cited as a theoretical justification for government deposit insurance. In the model, rational agents find it in their interest to withdraw their bank deposits if they suspect other depositors plan to do likewise. When a sufficient number of agents are expected to liquidate their accounts, a bank run ensues. Guaranteeing deposits through a system of government-administered deposit insurance removes the temptation to run on the bank and thereby precludes the need to ever use the deposit insurance. As Thomas Sargent makes clear, deposit insurance enters the model as a costless solution: The good news in the Diamond-Dybvig model ... is that if you put in government-supplied deposit insurance, that knocks out the bad equilibrium. People don't initiate bank runs because they trust that their deposits are safely insured. And a great thing is that it ends up not costing the government anything to offer the deposit insurance! It's just good all the way around [Rolnick 2010: 31]. Diamond and Dybvig (1983: 44) conclude, Government deposit insurance can improve on the best allocations that private markets provide. In practice, however, government-provided deposit insurance is not a costless solution. It is frequently invoked to cover the losses of failed banks. In the United States, deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC) is administered as a rainy-day fund. Each member bank pays a premium based on its risk rating and on the amount of insurable deposits held by the bank. Premiums are held in a deposit insurance fund (DIF) administered by the FDIC. When a member bank becomes insolvent, debts to its depositors are paid out of the DIF and premiums for all banks increase until the fund is restored. Annual premiums reflect the cost of operating and administering the system and recent losses due to bank failures. The cost of guaranteeing deposits through such a system is decidedly nonzero. The costs of providing insurance are sufficiently high as to warrant their inclusion in any reasonable model of deposit insurance. If the corresponding benefits of deposit insurance were sufficiently large and the alternative means of acquiring these benefits were either nonexistent or sufficiently costly, then ignoring the real-world costs of government-provided deposit insurance is perhaps appropriate. However, we do not believe this is the case. The benefits are not so large that one need not be concerned with costs, and there are potentially superior alternatives to government-provided deposit insurance. If one is to consider alternatives by engaging in comparative institutional analysis, a better understanding of the costs of government deposit insurance is required. In what follows, we explore the explicit costs of government-provided deposit insurance. We focus on the FDIC as a specific example. First, we review the DD model and show how FDIC deposit insurance differs from the model in several key respects. Second, we discuss the history of the FDIC, paying particular attention to how the maximum amount covered, number of bank failures, and cost of managing the deposit insurance fund have changed over time. Third, we briefly discuss private deposit insurance and other risk-constraining mechanisms as alternatives to government-provided insurance. Finally, we offer some concluding remarks. Theory of Deposit Insurance The DD model demonstrates that although banks can reduce individual risk by acting as financial intermediaries, they create systemic risk in the potential for bank runs. Under certain conditions, financial contagion can cause all banks, even solvent ones, to be run upon simultaneously. Diamond and Dybvig (1983) propose that government insurance can costlessly limit the risk of bank runs by guaranteeing the values of customer deposits. Here we review the DD model to demonstrate how deposit insurance under FDIC differs from that posited by Diamond and Dybvig. …