The Role of the FDIC
The purpose of the FDIC is to insure depositors’ funds. In the event that a bank is unable to satisfy customers’ requests for withdrawals, the FDIC will pay customers up to a certain amount per account. Deposit insurance discourages customers from withdrawing all of their money if the customers suspect that the bank is in financial trouble. In the event that there is a so-called “run” on the bank, it will most likely lead to a bank’s bankruptcy, because the bank has no more than about 10% of customers’ deposits. The other approximately 90% it has loaned out.
It is possible that a bank is very solid, but that customers’ perception is that the bank is in trouble. This perception could turn real if customers’ reactions lead to storming the bank, especially if their money is not insured. The FDIC’s strength is to guarantee people that their money is safe (up to a limit per account), so that a run can be prevented. If the bank is truly in trouble, the Federal Reserve usually intervenes by loaning reserves to the bank or attempting to find a more-solvent partner to merge with the troubled bank.
In the 1980s, the FDIC and its Savings and Loans counterpart, the FSLIC, ran into their own problems. Not only were Savings and Loans banks in financial trouble; the insurance company itself was in financial trouble. The government decided to intervene by merging the FDIC and the FSLIC and supplying it (and other overseeing agencies) with government funds to bail out insolvent banks.
Should Deposit Insurance be in the Hands of Private Companies?
Critics of the FDIC state that because it is non-profit, it does a poor job of overseeing and inspecting banks. Banks are getting away with making risky loans and sometimes even fraudulent loans without adequate knowledge by the FDIC. Most bank customers do not have any incentive to research a bank’s practices, because they count on the FDIC and other government agencies to do this, and they know that their accounts are insured by the FDIC up to $250,000 per account.
Some economists claim that private insurance companies do a better job at overseeing banks, because they are for-profit, and if a bank engages in improper practices, it will hurt the insurance companies’ bottom lines. In other words, private bank deposit insurance companies have greater incentives to do a more thorough job of evaluating bank loans and practices. An advantage to taxpayers is that private insurance companies are not subsidized by federal or state governments, unlike federal insurance agencies, such as the former FSLIC and the current FDIC. A disadvantage of private insurance companies is that during severe times of economic hardship, the insurance companies may not be solvent enough to sufficiently insure depositors.