3

A bank's basic function is to "borrow short and lend long". In other words, it borrows money from depositors over the short term, promising to repay it on demand, while it lends most of that money out over the long term to borrowers, for instance in the form of 30-year mortgages. This difference between these time frames, known as maturity mismatch, leads to systematic problems for banking. It makes banks vulnerable to crises, because if all the depositors show up one day asking for their money, the bank can't give it to them, because it's been lent out to borrowers, so the bank becomes instantly insolvent, even if it had no financial troubles before the depositors were worried about the bank's solvency.

Indeed, this used to happen frequently in the 1800's and early 1900's, most prominently in the Great Depression, until the FDIC came about. The FDIC makes all the banks pay a premium, and in exchange, whenever there's a run on a bank, the FDIC gives the bank money so that it can meet all its depositors' demands (at least up to a cap, like a hundred thousand dollars per account).

My question is, in the absence of the FDIC, why wouldn't banks just obtain private deposit insurance? Whenever people have significant risks, even if they're small, they tend to buy insurance. You don't have a very great risk of dying tomorrow, or having a car accident, or having a flood in your house, but still you buy insurance just in case. Companies of all kinds do the same: stores buy liability insurance, fire insurance, etc. So why wouldn't banks insure their risks similarly?

And it's not like banks don't buy private insurance already. For instance, when they lend out money, they buy insurance in case the borrower defaults on a loan - it's called a credit default swap. (Those were partially responsible for the financial crisis of 2008.) So what reason would they have for not buying insurance in case their depositors' demands exceed their reserves?

Is the problem that the premiums they would have to pay on the free market would be too high to make banking profitable anymore? If that's the case, then does that mean that the FDIC is not charging actuarially fair premiums to banks right now?

Any help would be greatly appreciated.

Thank You in Advance.

  • This may not be the place to bring this up, but you haven't accepted answers to any of your previous questions. It would encourage people to put work into answering your questions if they felt they might be accepted. – Avi Jan 4 '14 at 20:30
  • @Avi Thanks for pointing that out. I'll take a look to see what answers I should accept. – Keshav Srinivasan Jan 4 '14 at 21:25
  • @KeshSrinivasan I appreciate that. I think there used to be a "percentage of questions with accepted answers" stat on the profiles but I can't find it anymore. I don't really have to answer to this question specifically, but I'd imagine it has something to do with the fact that insurers aren't large enough to handle such a catastrophic thing as a bank run. Look what happened to AIG – Avi Jan 4 '14 at 22:09
  • @Avi Well, what happened to AIG was a systemic crisis, where all credit default swaps were at risk of having to be paid out. It's hard for any insurance company to survive a systemic event where it has to pay out on all policies, regardless of what's being insured; if all cars in the country were totalled simultaneously Geico might go out of business. But I don't see why insurance companies couldn't handle bank runs that weren't part of systemic financial crises. – Keshav Srinivasan Jan 4 '14 at 23:19
  • @Avi - they removed accepte percenntage as per one of the podcasts since it wasn't helping much. – user4012 Jan 6 '14 at 22:36
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Some people seem to think that having a private insurance is good enough and the people is to blame, but reality is not that simple.

TL/DR Let's put it this way: if you do not trust your bank to return your money to you... why do you think your insurance firm will be able to do so? To avoid people not trusting the bank the FDIC exists.

First, to understand: there are two types of issues with banks:

  • Crash/Bankruptcy: The bank owes $X. The assets of the bank (including money that the bank has borrowed) are less than $X.

  • Bank run: The bank owes $X. The assets of the bank are more than enough to pay $X, but most of them are not liquid enough (they are mostly as loans that will be paid in the coming months or years). By some cause, people loses trusts in the bank and wants to retire all of his money, and the bank cannot pay because not all of his assets can be converted to money so quickly.

The bankruptcy will be caused by the bank taking too much risks or by mismanagement, the bank run may be completely unrelated to the actual health of the bank.

Now, if the bank goes down in a period of economic growth, maybe insurance firms can take the hit. But the fact is that banks are most likely to go down during depression times (people and business who borrowed money fill for bankruptcy and the money will not be returned). So, what happens then?

Well, your insurance company did not take your money and bury it in a hole, waiting to need it. They invested it, most probably in conservative strategy. In other words, the insurers money is in the banks.

So Bank A crashes, and the insurers go and retire money to pay the claims. Now Bank B or C, who were more or less surviving the depression, find that suddenly they have lost a lot of liquidity, and that may find trouble returning people deposits. Some people are aware of it and go to the bank to ensure that they are the first in line to get their money back... and now Bank B and/or C are under too. Guess what happens next?

Other point of the issue is that insurance fees are calculated on the basis that disasters are few and strange. To put it simply: if a hurricane strikes your town and 10% of the homes are demolished, to make it even your insurance fee would be to have 10% of the cost of rebuilding your house (I do not know how much you pay but I bet not that much). If it is not and such a disaster exists, your insurance provider may very well go under, too. That is why special measures are taken for natural disasters. A bank going under is not a natural disaster, but (unless for small banks) it usually affects so many people that its effects are similar. The "too big to fail" term is not a meaningless one (that said, if a bank "too big to fail" fails, there should be a inquiry into the reason and a punishment for mismanagement if that happened).

Add to that the typical corporate shennanigans (remember when credit agencies gave A+ qualifications to everything their customers put in the market?) Ask for private insurance, and you will get the insurance offered to you in the bank office, by an insurance firm that is so closely tied with the bank that will have not funds when something happens.

And finally, imagine this scenario: you open your mail, and read a letter from your insurance company telling you that the fee for insuring your money in Bank A has gone from 0.1% to 0.5%. What would you do?

  • Nothing, because you are sure that if something happens your insurance company will pay you.

  • Run to the bank and get your money out of there as quickly as you can, fighting the hordes of customers trying to do the same, before the increased risk materializes.

Also it is worth noting that many people do not have that much money to deposit. If you tell someone that, added to almost null interest, they will have to pay for insurance to ensure the $20K that are their life savings, most probably many people will retire their money and store it at home.

OTOH, you cannot either go without ensuring at least partially the deposits, because that way any rumour (with base or without it) risks causing a bank run. At the appearance of even the slightest hint of recession, all people would retire their money from the bank and a total collapse would happen.

  • Although this answer goes into great detail about why insurance would not work, it doesn't mention why or how the current system is stable. To say it another way, if you can't trust an insurance firm to return your money to you, why do you think the FDIC will be able to do so? I mean, social security used to be considered a sure thing... – jpaugh Apr 20 '17 at 19:12
2

Your own question contains the answer: "or having a flood in your house". Most people not only neglect to purchase flood insurance (I recall seeing a figure of only 18%) - they ALSO choose to live in flood prone areas (not to be insensitive here, but New Orleans is bloody below sea level!!!) without flood insurance. Part of it is moral hazard (the government in the form of FEMA gives them free money to rebuild, so why not? Same stor as the banks and their bad risks), and part is just not thinking too rationally, or at all.

For most banks, the run on the bank seems unlikely, so they don't choose to hedge against it with insurance unless forced (and realistically, there weren't all THAT many systemic runs on the banks before 1920s. Black Swan and all that). Whether the actuarial rates on such insurance would be too high for the bank to sustain may be a factor, but the problem is more that they don't have any way to estimate the risk from the bank run to even make such a decision in the first place. Nissim Taleb discussed this in detail, in Black Swan and other books.

  • While I suspect that market forces make run insurance financially inviable, it would be nice if you could provide some citations or some maths based on previous instances of this kind of thing to demonstrate your points, though I recognize that it may be difficult given that OP is asking about a hypothetical others may not have considered. – Avi Jan 6 '14 at 22:48
  • @Avi - en.wikipedia.org/wiki/List_of_bank_runs. You will note that there aren't all that many listed before 2000, though how thorough that list is, remains to be questioned. Here's another list, same result: nymag.com/news/intelligencer/topic/banks-2012-6 – user4012 Jan 6 '14 at 22:50
  • Again, the main reference is Taleb. We just aren't ANY good at estimating risks of rare catastrophic events. So there's no good way to actuary that. – user4012 Jan 6 '14 at 22:53
  • @DVK I think those are lists of major bank runs, not all bank runs; I think bank runs were fairly common in the 1800's when there was no FDIC. And I'm not talking about systemic crises and black swan events; insurance companies are anyway not built to handle systemic events when all policies pay out. I'm talking about bank runs that are not part of systemic crises. – Keshav Srinivasan Jan 7 '14 at 3:29
2

The FDIC protects "small" depositors, with less than $250,000 in a single bank (formerly $100,000). That is, if the bank fails, these depositors will be made more or less whole.

These are the people that are most in need of protection. The "big players" can take care of themselves. But the small ones, people for whom $25,000 would represent a huge loss, need the protection for their day to day lives.

The amounts of money are relatively small, but the numbers are huge; we're talking nearly 90 percent of the U.S. population, whom you don't want out on the streets, if something bad happens to the banks.

  • 1
    But that's just an argument about why deposit insurance is important, not why it's not bought on the private market. – Keshav Srinivasan Jan 21 '14 at 20:56
  • 1
    @KeshavSrinivasan: During the Great Depression of the 1930s, when banks closed right and left, this became a public policy issue. Ditto in our time, for "Obamacare." – Tom Au Jan 21 '14 at 21:20
  • First of all, I don't understand your Obamacare comment. Second of all, I know there were lots of bank failures in the 1930's which led to the creation of the FDIC, but my question is, why didn't banks buy private deposit insurance before the FDIC? – Keshav Srinivasan Jan 21 '14 at 22:56
  • 2
    @KeshavSrinivasan: Banks "did their own thing" before the FDIC, so the Federal government basically said, "If we have to bail you out, we'll charge you for it (through FDIC). To show how arrogant the banks were, JP Morgan was the US' de facto central bank until the 1930s. So said, Benjamin Strong of the Bank of England. Until JP Morgan proved unequal to the task. – Tom Au Jan 21 '14 at 23:05
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In the context of systemic risk due to banking panics, the Federal Deposit Insurance Corporation has the political effect of giving bankers an overpowering incentive to influence the Federal Reserve System's Federal Open Market Committee and the Federal Reserve Board of Governors to implement system wide policies for extension of credit which socialize and cartelize the banking sector to work towards its own common purpose.

Because the FDIC is statutorily authorized and politically expected to threaten to draw on the capital accounts of every FDIC covered bank (via FDIC assessments) to meet insolvency shortfalls, the bankers have an incentive to protect banking sector profits by regulating out debtors that are bad credit risks, but not so much that the profits of bank holding companies are impaired.

In consideration of these profits and easy war finance, the banking sector has adopted a policy of a declining purchasing power for the fiat credit dollar coupled with shocks (the business "cycle") to manipulate the commodities and the stock markets (to make profits on the side). The declining purchasing power protects against bad credit of non-bank debtors whilst taking the heat off of moneylenders in regards to allegations of usury.

Actuarial considerations aren't really relevant in the big picture, because all prudent banks attempt to guard their capital accounts by diversification of credit risk and, if necessary, true insurance for things like death of the debtor. Absent the FDIC and Federal Reserve, banks would substitute a good credit rating and high capitalization for "insurance" or credit default swaps, because that will enable them to take cash loans from other banks to meet cash shortfalls, and ideally to prevent withdrawals in the first place.

As for cash shortfalls in the event of a bank run, that has no actuarial consideration because it is a systemic risk which is handled by the private Federal Reserve Banks being ordered by the FOMC (a public US agency) to issue circulating Federal Reserve Notes to meet withdrawal claims, and by policies of panic prevention which include FOMC lowering interest rates, FRBG implementation of BASEL capital requirements, and many asset side banking regulations.

Once the FDIC and FRS exists, the only remaining question for the banking sector is whether the losses will be paid by the banking sector as a whole (for banks within industry standard) or by the stockholders of banks (for banks outside of industry practice). Recently there is a trend to impose costs on US Taxpayers via Bailout legislation.

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