Certificate deposit insurance

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Spawned by a compromise to ensure passage of the Glass-Steagall Act in 1933, federal deposit insurance is one Depression-era program that is likely to remain part of the financial landscape for the foreseeable future. But pressure to reconsider its role in the U.S. financial system is mounting. The Gramm-Leach-Bliley Act (GLBA) is dismantling many of the statutory limits on financial consolidation that were the heart and soul of Glass-Steagall, altering the face of the financial services industry. GLBA and the Reigle-Neal Act (1994), which dismantles interstate branching restrictions, promise increased integration of financial markets and more competition among financial firms. Heightened competition in funding markets has prompted some banking associations and policymakers to recommend raising the deposit insurance limit to $200,000.

In March 2000, the Federal Deposit Insurance Corporation (FDIC) began to formally consider this proposal and other reforms. It issued an options paper in August 2000, whose purpose was "to frame the issues confronted by the FDIC and begin the discussion of options for addressing those issues." (1) Any discussion of federal deposit insurance and the proposed reforms to the current system needs to address two basic questions. First, what are the net social benefits of providing federal guarantees for bank and thrift deposits? Second, given that we have decided a system of federal deposit insurance improves social welfare, how can we structure the system of guarantees to deliver the benefits most effectively--that is, at the lowest cost to society?

To answer these questions, we must first clarify our motives for providing deposit guarantees. In other words, we must understand why the market outcome is deemed unsatisfactory and what the social objectives we hope to achieve through government intervention are. Such an analysis is important because the structure of our system of federal deposit guarantees is likely to be different if the social objective is to protect small savers, subsidize the funding of bank assets, or stabilize the banking system. In addition, identifying and understanding the social objectives for deposit insurance is essential for assessing the net social benefits of the various reform proposals, including changes in the insured-deposit limit.

This Economic Commentary seeks to shed light on the issue of deposit insurance coverage by examining who would benefit from increases in the insured-deposit limit. (2) Potential benefits to three sets of stakeholders--depositors, community banks, and taxpayers--are discussed. Understanding who stands to gain from increases in the insured-deposit limit helps to ascertain whether such an increase is consistent with the social welfare objectives we establish for federal deposit guarantees.

* Benefits to Small Savers

Proponents of federal deposit insurance argue that it provides two social benefits. First, they claim it improves economic efficiency. With deposit insurance, the deposit insurer can monitor the condition of banks more cost-effectively than many small depositors, spread out around the country, can. Second, they claim that deposit insurance creates a more equitable banking market for small savers. Proponents of deposit insurance argue that it is neither reasonable nor fair to expect small savers to monitor banks. After all, it is common to presume, correctly or not, that small savers are financially unsophisticated and lack the ability to assess the condition of a firm whose portfolio of assets consists largely of information-intensive assets--loans. Moreover, even if small savers are financially savvy, the costs of monitoring a bank for them may outweigh the benefits and therefore, it may be rational for them to not actively monitor the condition of their bank.

Is the current $100,000 per account limit sufficient to protect small savers? The answer appears to be yes. After all, the average deposit in these accounts is less than $6,000. (3) Close to 99 percent of all domestic deposit accounts in commercial banks are under the $100,000 deposit-insurance limit. This breadth of depositor cover age compares favorably to depositor coverage historically. For example, when the Congress established our system of federal deposit guarantees in 1934, the initial insured-deposit ceiling was $2,500. It is estimated that the $2,500 limit afforded full coverage to 96.5 percent of depositors in FDIC-insured banks. (4)

According to Federal Reserve Board figures, the median balance in transaction (checking) accounts for all families is only $3,100, and the median value of certificates of deposits held by households is $15,000 (5) (see table 1). These median deposit levels, taken individually or combined, are well under the current $100,000 insured-deposit limit. Moreover, even the combined median checking account balance of $19,000 and the certificate-of-deposit balance of $22,000 for households with the highest incomes (more than $100,000) is less than half of the current insured-deposit limit.

The current $100,000 ceiling is even more generous when one considers that it applies to a single deposit account at a single insured institution. Depositors have two ways they can increase their coverage above $100,000. First, a depositor can maintain accounts at multiple insured depositories. With around 9,800 FDIC-insured banks and thrifts, there is almost unlimited coverage available to even the most well-heeled depositor. Second, FDIC rules treat individual accounts and joint accounts as separate accounts for insurance purposes. For example, through a combination of individual and joint accounts, a family of four can have $3.2 million in fully insured deposits in a single institution. (6) The current deposit insurance ceiling of $100,000 appears to exceed what is required to protect small savers.

* Benefits to Community Banks

Community banks and thrifts continue to lobby for increases in the insured deposit limits on different grounds of equity. These institutions argue that the liabilities of large banks carry a conjectural guarantee of the government--often referred to as the too-big-to-let-fail doctrine. In other words, community financial institutions maintain that too-big-to-let-fail puts large institutions at a competitive advantage in deposit markets, and an increase in the insured-deposit ceiling is needed offset this. (7)

Community financial institutions neglect three important considerations from their equity arguments. First, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 eliminates the too-big-to-let-fail doctrine by explicitly prohibiting forbearance to uninsured depositors and creditors of any failed bank or thrift institution unless the FDIC seeks and is granted a systemic risk exemption. Moreover, the prompt corrective-action provisions of FDICIA apply equally to all banks and thrifts, irrespective of size. Second, Congress appears to have leveled the playing field between large and small depository institutions in the GLBA. This legislation provides community financial institutions with superior access to funding from the Federal Home Loan Banks by allowing them to borrow against their small business, small farm, and small agricultural lending portfolios. Finally, any changes to the current system of federal deposit guarantees must be fair to large banks, small banks, and taxpayers.

Ideally, to identify and measure the benefits of increasing the insured-deposit limit for community banks, we would examine changes in funding costs and deposit growth resulting from raising the ceiling. However, arriving at such estimates using past increases in the insured-deposit limit is problematic given the lack of available data. Moreover, even if such estimates were possible to construct, the quantum differences between the structure of our banking system today and the attendant regulatory system vis-a-vis 1981--the last time the deposit insurance limit was changed--raise serious questions as to the applicability of those estimates to today.