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If you walk into a bank, you will likely see a sign that says FDIC insured. The FDIC stands for Federal Deposit Insurance Corporation. This government program insures deposits up to $250,000 in principal plus accrued interest due to the depositor in case the bank fails. To take advantage of this insurance, if you have more than $250,000 in cash, it makes sense to open a new account at a separate bank to get additional insurance. Because of this loophole, the FDIC insures much more than $250,000 per person. The theory behind that number is to prevent the depositors from losing their money when a bank fails. This failure could occur if the bank makes risky bets that lose value or if more than 10% of depositors decided to withdraw all of their money at the same time, causing a run on the bank. By the way, the reason only 10% of capital needs to be withdrawn and not 100% is due to fractional reserve banking

The goal of the FDIC is to prevent a bank failure from destroying people’s savings. This insurance is supposed to remove that risk. As with most things in life, what sounds too good to be true usually is. There is no free lunch. In the case of FDIC insurance, the risk that banks undertake and the risk the depositors take is transferred to the government. No risk is eliminated however since taxpayers foot the bill when banks fail. They fund the money depositors lost. This situation doesn’t sound too bad at face value, but the only way to assess the risk is to dive into the details.

Here is a list of bank failures dating back to 2000. Since 2009 there have been more than 500 bank failures. As of March 2017, there are 5,856 FDIC insured banks. To say that bank failures are rare, would be an understatement.

When risk is transferred to the government, this creates an incentive for banks to take on even more risk because they know the government insures them in case of a loss. This is what is known as a moral hazard. The FDIC is the backbone of the ‘too big to fail’ phenomenon where banks, which are considered systemically important, are bailed out. The domino effect is also in play because a small bank failing could cause a medium bank to fail which could cause a systemically important bank to fail. As the old saying goes, the chain is no stronger than its weakest link. The interconnectedness of the banking system combined with banks undertaking increasingly risky investments due to moral hazard creates an unfathomable risk that places you, the depositor and tax payer at peril.

The government taking the risk off the shoulders of banks is why regulations such as capital requirements exist. It’s a mistake to say greed on Wall Street causes banks to take too much risk which causes them to inevitably run into problems. The real problem is moral hazard along with agency risk. Agency risk is the risk that management doesn’t act in the best interest of shareholders. A bank CEO can decide to take excess risk to get higher bonuses in the short run. The worst-case scenario is the bank fails and the government bails it out. The CEO may still walk away with a golden parachute, a form of severance compensation after dismissal.

The government is like a dog chasing its own tail when it comes to risk in the financial system. It’s always trying to regulate new aspects of the financial system to prevent a crisis. It would be more efficient if the government stepped out of insuring bank deposits and let banks take the risk themselves. When moral hazard is removed, all parties work in their self-interest making the system more stable.

In addition to creating moral hazard and by extention increased risk, overregulation, which is often justified as a necessary means to limit so called greed on Wall Street makes the problem even worse. Over-regulation prevents lending growth. Credit growth is the lifeblood of the economy. As much as the government wants to regulate banks to lower risk, if it steps too far, it can limit economic growth. Dodd-Frank is one example of a regulations which hurt community banks because they can’t afford to comply with the law.

The Dodd-Frank Act imposed a new regulatory regime upon the financial services industry with the goal of promoting financial stability and protecting consumers. The result, however, has been over 22,000 pages regulations affecting the entire industry. In the years since the law was passed, the financial services industry has witnessed a steady decline in the number of community banks operating in America.

Hurting community banks increases systemic risk since this results in an increase in market share for large systemically important, otherwise known as “too big to fail”, banks.  Substitute the word “bank” for depositor and the word “government” for taxpayer and you realize who is really supporting the systemic increase in risk. Its you and you.

If you’re wondering what the world would look like without FDIC insurance, there are many options to solve this problem without regulations. A depositor can pay a 100% reserve bank to hold its money in a checking account. The full reserve system is an alternative to the fractional reserve system as the bank will be forced to hold all the money the depositor puts in the bank instead of lending it out.

Full reserve banking is one option. Another option would be companies which review banks and analyze which banks take the most risk and which ones are the safest. In the current scenario depositors only look at which bank provides the highest interest rate and the best customer service.  When depositors begin to pay attention to the risk profile of banks, it will encourage banks to act more responsibly with their capital, thus making them safer for depositors. Allowing the consumer to regulate the banks in a free market enforces that only the safest and most successful banks are left standing, creating a favorable circumstance for both the growth of the economy and reducing the potential risk of events that could negatively affect the economy. People, managing their own capital, are the best decision makers. No consumer watchdog or any other organization can make decisions better than someone acting in their own interest. It doesn’t mean that decisions will be made without error, however in aggregate it ensures that the consumer educates themselves and is aware of all risks associated in the preservation of their capital. Think about it in these terms – are you more likely to spend your own money that you have worked hard to obtain with greater care, or if you someone gave you a money as a gift in the same amount? 

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