Updated: May 3
Created in the mid-1930s, the Federal Deposit Insurance Corporation (FDIC); a government-owned corporation enacted by US Congress; was implemented as a regulatory agency to protect depositors and prevent further bank runs. Indeed, the United States has a long history of bank runs. Bank runs in the United States mainly occurred during the National Banking Era (1864-1912), which was marked by the National Banking Acts of 1863 and 1864. The purpose of the National Banking Acts was to help finance the war effort by increasing the demand for federal government debt and to promote a stable uniform currency. Thus, the goal of involving the government in the financial system was to minimize bank failures. Interestingly enough, the National Banking Era was the period in which the U.S. financial system experienced the most bank failures. The numerous bank failures during the National Banking Era are what led to the creation of the Federal Reserve in 1913.
Through the Federal Reserve Act, the Federal Reserve was created to set U.S. monetary policy to promote maximum employment and price stability in the national economy. However, the Federal Reserve is the very institution that engineered the Great Depression and the subsequent bank failures that occurred during the Depression. One thing that central bankers and political leaders noticed about bank panics was that depositors were not insured; meaning that when a bank became insolvent, depositors lost all their money. Thus, in order to prevent depositors from losing their money when a bank becomes insolvent, the U.S. government decided to create a regulatory agency that will protect depositors. Hence, the FDIC was created, and its mission was to guarantee that depositors will recover their money up to a certain amount.
In the first years of its implementation, the insurance limit was set at $5,000. But over the years, the insurance limit has been raised consistently to be eventually set to $250,000. Today, if a bank becomes insolvent, depositors who have $250,000 or less, will be guaranteed to recover the full amount of their bank account. But for those who have more than $250,000 in their bank account, they were considered uninsured, thus, lose the remainder of their funds. One common factor that links the recent bank failures (SVB, Signature Bank, & First Republic Bank) is that each of the failed banks had a high share of uninsured depositors. As a result, the FDIC has been considering lifting the insurance limit. Some speculate that the FDIC wants to set the new limit to $250 million while others speculate that the FDIC wants to make the limit indefinite, meaning that depositors will be insured regardless of the amount they have in the bank.
Lifting the insurance limit to whether $250 million or even making it indefinite will not solve the problem but, on the contrary, it will exacerbate it. The reason is that banks will act more recklessly and make more unsound investments on the premise that if they become insolvent, depositors will be insured no matter what. This will throw bankers’ ethical and fiduciary duties out of the window. Worst, if the insurance limit was lifted, the taxpayer will be the one bearing the burden of insuring depositors. The best way to prevent bank failures is to privatize the FDIC.
Privatizing the FDIC will force banks to act more responsibly because they will be forced to have skin in the game. How will the privatization of the FDIC make banks act more responsibly? If the FDIC were to be privatized, banks will first have to pay a fee for registering their insurance. The privatized FDIC will only insure depositors up to the amount that the bank invested and shareholders (if the bank decided to pay an additional fee to shareholder insurance protection). So if a bank invested little in the privatized FDIC, only a small share of their depositors will be insured. This will make potential depositors reluctant toward that bank. Therefore, the bank will have to increase its stake in the privatized FDIC and make sounder investment to prevent any significant loss that could lead to bank insolvency. A privatized FDIC could lead to an optimal banking system that will minimize its exposure to risk of insolvency.