What is the economic rationale for government-backed deposit insurance? Case Study: The Federal Deposit Insurance Corporation (FDIC) The most important government agency is The Federal Deposit Insurance Corporation, whereby each depositor is insured to at least $250,000 per insured bank in the case that a financial intermediary should fail. This protects people’s deposits so that they do not face a great financial loss. * When a bank fails it means they are unable to meet their obligations to pay its depositors and other creditors.
Therefore deposit insurance was introduced in 1934 in order to protect those, for when a financial intermediary failed. * In the first 10 months of 1930, a total of 744 US banks failed. In November and December of that same year, 600+ more banks failed. Throughout the entirety of the Great Depression, over 9,000 US banks failed, which is by far the worst stretch in US history when it comes to bank failures. * The main reason for deposit insurance is that individuals are more inclined to put all their money in the bank, instead of holding on to it in the case of their deposits becoming inaccessible due to the bank being illiquid or insolvent.
Therefore by having insurance it provides a reason for these individuals not to have to pull all their money out of the bank by knowing that the government is guaranteeing their deposits. As a result, the entire banking system becomes much more secure and stable. * Banks receive money from people lending them money in the form of savings and checking accounts. With more money put in accounts, the bank has more funds to access. This means there are more funds to lend, which in turn will decrease the interest rate.
However if people lost confidence in banks, their money would go elsewhere, for example into property investment. Leaving banks insolvent and going out of business. * Another benefit for banks is the protection offered to them through deposit insurance. For example if a bank made too many bad investments and start to fail, they will not essentially go bankrupt. Instead the Federal Deposit Insurance Corporation will put them under new management. Should there be any limits to such insurance?
With recessions happening all over the world and the euro crisis, people are no longer confident in their bank. They prefer to hold onto their money instead of saving it in a bank account. By having the safety net of insurance, people will feel they can put their money in a safe place within the bank. When you have extremely large financial institutions or markets, their failure has the potential to bring down the entire financial system. In cases like this we need the government to provide the support.
Putting a limit on a valuable corporation that has recently failed can cause a loss of millions of pounds/euros/dollars in an economy. On the other hand having a limit on the insurance can mean that when the Federal Deposit Insurance Corporation raise the limit then depositors will put more money into their bank accounts. So when the government increase the limit, suddenly the banks will see an inflow of relatively cheap funds. This can suggest the banks are in a better situation.
The main reason for having limits is that if there were no caps on insured deposits then investors would leave the Treasury market and put all their money into a bank account that ensures a government guarantee. The investors would be getting the same safety and earn higher yields from being with their local bank. In a situation where all the banks have a government-backed guarantee, they are forced to compete for deposits by offering a higher interest rate. This will result in banks increasing their risks of failing within their lending.