As a crisis response, raising FDIC protection limits from $100,000 to $250,000 per depositor per account was very effective at alleviating customer fears, stopping vital depositor money from fleeing and keeping banks afloat. It was the right decision at the time. But now that the crisis has subsided and the U.S. banking system has come back from the brink, FDIC blanket guarantees need to be rolled back to pre-crisis levels.
FDIC insurance is more than just a sticker affixed to a bank door, it is a gold-plated guarantee that the government will step in and make depositors whole. Bank customers accept that they will earn a quarter of a percent or less on their deposits because they understand that their money is protected. And banks large and small benefit from this access to a cheap and dependable source of funding.
When it began, FDIC insurance provided depositors with only modest protection. The initial coverage limit in 1934 was $2,500, or less than $45,000 in today's dollars. Six months later, the limit was raised to $5,000 (still less than $86,000 adjusted for inflation) and the risk-sharing arrangement between banks, depositors and the government was forever changed. As long as depositors stayed within set limits, they assumed zero risk. But if the dollar size of bank failures exceeded the fees collected from the banks, then the government, and taxpayers, would become the ultimate financial backstop.
In recent years, FDIC insurance has experienced mission creep. Having grown at over twice the rate of inflation, it now provides more than modest protection.
Few Americans have the means to keep deposits of $250,000 and benefit from this protection. Instead, the larger limits have tilted the risk-sharing in favor of wealthier depositors and banks themselves.
For-profit intermediaries such as the Certificate of Deposit Account Registry Service have sprung up, helping fat-cat depositors slice deposits into smaller chunks to maximize FDIC coverage. As the limits have increased, the creativity of these firms has kept pace.
Meanwhile, the sliding-scale insurance premiums charged to banks haven't increased commensurate with the level of newly created risk in the system. After the coverage limit was expanded by 150 percent, the fees paid by banks rose, on average, only 10 percent. This is a bargain for banks big and small, but potentially a significant cost to taxpayers, who are left inappropriately exposed. The FDIC Deposit Insurance Fund, which topped $54 billion in 2008, was $20 billion in the hole by 2010 as bank failures piled up. The deficit is gone now, but the DIF remains grossly underfunded at just 0.32 percent of deposit reserves, far from the 1.35 percent reserve ratio required by 2020.
The bank bailouts of 2008 should have been a wake-up call to legislators that they are in the risk management business and need to do a better job of protecting taxpayers.
Lawmakers seemed to have heeded the call at the end of 2012, when they refused to extend the expiration date on the FDIC's Transaction Account Guarantee program, another crisis-era measure.
Unfortunately, the $250,000 coverage limit has no set expiration date. The Dodd-Frank Act recklessly put taxpayers on the hook for a permanent increase in FDIC deposit protection.
But with depositor confidence restored and banks awash in cash, it makes sense to roll back FDIC protection to $100,000 per depositor per account. At lower limits, banks would maintain sufficient deposits, but they also would have more incentive to behave prudently so as to attract and retain depositors. Alternatively, if banks want to keep limits at the current high level, they should pay the true market price for such insurance (in which case premiums at a minimum should double).
Either way, taxpayer risk certainly would be better served. And the 7,000-plus commercial banks that enjoy the many benefits of FDIC insurance would be sending a powerful message to the tax-paying public: we appreciated your support in our time of need and now it is our duty to restore the appropriate market balance between those who shoulder the risk and those who benefit from it.
Mark Williams, a former Federal Reserve Bank examiner and the author of "Uncontrolled Risk," about the collapse of Lehman Brothers, teaches finance at Boston University. This article appears in the February issue of American Banker Magazine.