The FDIC was created to restore public confidence in banks following the many runs on banks during the Great Depression. It guaranteed that deposits up to a certain amount would be paid back by government even if the bank went bust. However, in return for confidence in the banking system, federal deposit insurance introduced a systemic problem of moral hazard—the incentive to engage in more risky behavior that results when adverse consequences are lessened by a third-party guarantee.
This moral hazard affects both banks’ and their customers’ behavior. 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.
This moral hazard surely played a role in the financial crisis of 2007-8. However, the response from government was to increase deposit insurance from a ceiling of $100,000 to $250,000, first as an emergency measure and then by law.
Now that the dust has settled, Congress should act to remove or minimize the perverse incentives of deposit insurance. At the very least it should reduce the deposit amount guaranteed from $250,000 back to its pre-crisis level of $100,000, and preferably reduce the amount further to $50,000. As the median savings account for Americans is just $5,200, this change would only affect a very small number of wealthy Americans, who probably have other opportunities to protect their wealth rather than relying on explicit taxpayer support.
I also suggest some other changes such as reducing the FDIC’s role in bank resolution and removing the Consumer Financial Protection Bureau’s seat on the FDIC board.