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Deposit Insurance

2 March, 2015 - 12:11

From a customer’s point of view, the most important form of regulation comes in the form of deposit insurance. For commercial banks, this insurance is provided by the Federal Deposit Insurance Corporation (FDIC). Insurance funds are maintained through a premium assessed on banks for every $100 of bank deposits.

If a commercial bank fails, the FDIC guarantees to reimburse depositors up to at least $100,000 per account, temporarily raised to $250,000 through 2009. In practice, the FDIC has made good on all deposits in failed banks, regardless of the size of the account. From a depositor’s point of view, therefore,it is not necessary to worry about a bank’s safety.

One difficulty this insurance creates, however, is that it may induce the officers of a bank to take more risks. With a federal agency on hand to bail them out if they fail, the costs of failure are reduced.Bank officers can thus be expected to take more risks than they would otherwise, which, in turn, makes failure more likely. In addition, depositors, knowing that their deposits are insured, may not scrutinize the banks’ lending activities as carefully as they would if they felt that unwise loans could result in the loss of their deposits.

Thus, banks present us with a fundamental dilemma. A fractional reserve system means that banks can operate only if their customers maintain their confidence in them. If bank customers lose confidence,they are likely to try to withdraw their funds. But with a fractional reserve system, a bank actually holds funds in reserve equal to only a small fraction of its deposit liabilities. If its customers think a bank will fail and try to withdraw their cash, the bank is likely to fail. Bank panics, in which frightened customers rush to withdraw their deposits, contributed to the failure of one-third of the nation’s banks between 1929 and 1933. Deposit insurance was introduced in large part to give people confidence in their banks and to prevent failure. But the deposit insurance that seeks to prevent bank failures may lead to less careful management—and thus encourage bank failure.