Congress keeps propping government-backed deposit insurance up, risk keeps rising

On Sunday, the Federal Deposit Insurance Reform Act of 2005 marked its 20^th anniversary. This Act consolidated the Bank Insurance Fund and the Savings Association Insurance Fund into a single Deposit Insurance Fund. Consolidating the funds removed legal and operational constraints that had previously limited how the Federal Deposit Insurance Corporation (FDIC) could adjust coverage or set premiums, giving regulators and Congress a simpler, more flexible framework.

Although the law did not raise the standard $100,000 limit, it increased coverage for certain retirement accounts to $250,000 and indexed them for inflation. This streamlined structure set a precedent for future expansions, such as the temporary increase to $250,000 for all deposits during the 2008 financial crisis. As with many supposedly temporary government measures, this increase was later made permanent through the Dodd-Frank financial overhaul of 2010.

Two decades later, Congress is still considering even larger deposit insurance limits. In October, Sens. Bill Hagerty (R-TN) and Angela Alsobrooks (D-MD) introduced the Main Street Depositor Protection Act (S. 2999). This bill would raise the deposit insurance limit from $250,000 to $10 million, a forty-fold increase. In the House, a hearing in November explored the future of deposit insurance.

Recent House bills illustrate the focus on expanding deposit protections. H.R. 4551, the Employee Paycheck and Small Business Protection Act, would extend insurance-like coverage for business transaction accounts to higher thresholds. H.R. 5317, the Community Bank Deposit Access Act of 2025, would adjust how certain deposits are treated to help community banks attract stable funding. These proposals reflect a bipartisan focus on increasing coverage as the primary solution.

Even after 20 years, the Federal Deposit Insurance Reform Act of 2005 exemplifies a persistent Beltway mindset: when problems with deposit insurance arise, it makes more political sense to tinker with and expand coverage. This overlooks the unpleasant reality that government-backed deposit insurance itself is, by its very design, the problem.

 What is deposit insurance?

Deposit insurance is a government guarantee on bank deposits. In the US, FDIC insures deposits at participating banks up to a statutory limit, which is currently $250,000 per depositor, per institution, per account ownership category. The premise of deposit insurance is preserving confidence in the financial system and preventing destabilizing withdrawals during periods of stress. Deposit insurance was a response to the wave of bank runs during the early 1930s that preceded its implementation in 1934. Deposit insurance does not transform deposits themselves into inherently government instruments. Rather, Congress created the FDIC as an independent federal agency that runs a government‑mandated insurance program.

The FDIC maintains the Deposit Insurance Fund (DIF), which is funded by insurance premiums that banks pay based on the size and risk of their deposits, along with interest earned on the Fund’s investments. The DIF does not rely on annual appropriations from Congress, it accumulates reserves over time and is used to pay insured depositors up to the legal limit when an FDIC-insured bank fails. If the Fund is ever insufficient, the FDIC has authority to borrow from the US Treasury, which effectively provides a government backstop. Because this protection is backed by the full faith and credit of the United States, insured depositors face minimal risk of loss.

When protection breeds risk

This protection issue can be summarized in two words: moral hazard. Moral hazard arises when an individual or institution is insulated from the consequences of risk and has weaker incentives to act prudently. When losses are borne by someone else, risk-taking becomes artificially attractive.

Moral hazard matters even more in financial markets because risk-taking is central to the system itself. To quote CEI Senior Fellow Iain Murray, “Banks are more likely to make risky investments knowing their customers’ deposits are guaranteed. Customers, meanwhile, are less likely to pay attention to banks’ business practices. If all banks are perceived as being equally safe, customers will choose based on other considerations beside sound investment practice, resulting in a loss of competitive market discipline in the banking system.”

Insured deposits carry virtually no market risk, meaning that deposit insurance shields depositors from banking losses while transferring that risk to the system as a whole. By providing banks with a guaranteed, low-cost source of funding, deposit insurance reduces the discipline that would naturally arise from risk-sensitive deposit pricing and encourages banks to favor safer, insured deposits over costlier uninsured funding.

Deposit insurance premiums distort bank decisions

In its review of the empirical research on deposit insurance, the Federal Reserve acknowledges that while deposit insurance can have a stabilizing effect during an economic crisis, it also notes that “deposit insurance premiums are not accurately pricing the stabilizing effect, leading to a distortion in the decisions made by banks.”

While deposit insurance is often credited with promoting stability by reassuring depositors, the way it is funded can create unintended economic side effects. A study from the FDIC itself finds that when banks are required to pay higher deposit insurance premiums, those costs do not simply disappear; banks reduce lending instead.

Because banks rely heavily on deposits to fund loans, higher insurance premiums effectively raise banks’ cost of doing business. Rather than fully passing those costs on through higher fees or deposit rates, banks respond by cutting back on lending, especially during economic downturns. The study estimates that a relatively modest increase in deposit insurance premiums led to a measurable decline in bank lending, with smaller community banks being especially affected. In practice, this means fewer loans, higher borrowing costs, and reduced access to credit for households and businesses, which undercuts economic activity at precisely the moment when credit is most needed.

Deposit insurance ensures greater instability and risk on the whole

CEI Senior Fellow John Berlau has warned about how deposit insurance can lead to economic fallout. This tradeoff between stability and fewer loans is compounded by the fact that deposit insurance increases the likelihood of banking crises. This increased likelihood is confirmed both by a research paper from the National Bureau of Economic Research (NBER) and an International Monetary Fund study coming to that conclusion after examining deposit insurance trends in 61 countries.

Another study from NBER calculated that a one-standard-deviation increase in deposit insurance results in an increase of roughly 40 percent of a standard deviation increase in crisis risk and crisis severity. The effects on crisis risk range from 24 percent to 50 percent of a standard deviation increase, and on crisis severity from 26 percent to 43 percent of a standard deviation.In layman’s terms, the authors found that more generous deposit insurance is associated with a statistically meaningful increase in the likelihood of a financial meltdown.

This economic effect is not transient. To put this effect into context, historical analysis from the Federal Reserve Bank of Boston illustrates that real GDP per capita falls by about 1.3 percent one year after banking distress and unemployment rises about 1 percentage point within two years. When the financial crisis is extreme in global terms, the global GDP decreases by 2.95 to 4.5 percent.

In other words, the “stability” deposit insurance provides comes only after it has already encouraged risk-taking and instability. Stability produced by a policy that itself creates financial fragility is a weak justification for maintaining government-backed deposit insurance.

Deposit insurance is a harmful government subsidy, not a safety net

Put simply, deposit insurance is a government subsidy that lowers banks’ funding costs and blunts market discipline while fueling the likelihood of the next financial crisis. In contrast, private insurance coverage comes from private companies that charge premiums based on risk, which in turn gives banks a greater incentive to manage themselves more responsibly. Removing regulatory barriers for de novo banks would increase competition in the banking industry. Not only does it give depositors more choices, but it rewards well-run banks while punishing the poorly managed ones. A third option would be to let regulatory off-ramps tied to capital operate under fewer regulatory burdens if they can hold enough equity to cover losses. This would mean that the risk is with the shareholders, and not the everyday taxpayer.

Each of these market-based approaches, which are not mutually exclusive, aligns risk with those who actually should bear it instead of exposing taxpayers to bank losses or encouraging reckless behavior. Since Washington is still propping up this risk with deposit insurance, the next financial crisis is not a matter of if, but when and how much more disastrous it will be with government-backed deposit insurance.