Why Not Raise the FDIC Insurance Limit?

September 26, 2008

Disclaimer: deposit insurance is not my area of expertise. The above question is not rhetorical; I am actually interested to know if there are reasons to avoid raising the FDIC limit, in light of advantages I can see to doing so.

It looks like the proximate cause of Washington Mutual’s failure was a run by depositors. Given this, should we be looking at raising FDIC insurance limits to increase depositor confidence in tottering banks and discourage runs?

The Deposit Insurance Limit

Insurance from the Federal Deposit Insurance Corporation covers most bank deposits in the United States, but only up to a limit of $100,000 per depositor, per institution. The $100,000 limit is not indexed to inflation, and has not been increased since 1980. This means that, in real terms, the insurance limit falls every year. If the limit had risen along with the Consumer Price Index since 1980, it would exceed $248,000 today.

The percentage of U.S. bank deposits that are uninsured because they exceed the $100,000 limit is nontrivial—thirty-six percent, or $2.6 trillion of $7.1 trillion total deposits, according to Bloomberg News. Many businesses require operating accounts well in excess of $100,000 in order to support daily operations, though some of the excess deposits are owned by individuals.

Normally, depositors need not worry about banking with an iffy institution, because they can rely on FDIC insurance. However, since 36% of deposits are uninsured, many depositors have excellent reason to participate in a bank run.

The WaMu Failure

According to today’s Wall Street Journal (page A16 of the print edition), that’s exactly what happened to Washington Mutual (emphasis added):

Starting September 15, the day that Lehman filed for bankruptcy protection, WaMu’s customers began heading for the exits. Over the next 10 days, they yanked a total of $16.7 billion in deposits, according to the Office of Thrift Supervision [the chief regulator overseeing WaMu]…

Federal regulators said the exodus of deposits left WaMu “with insufficient liquidity to meet its obligations.” As a result, WaMu was in “an unsafe and unsound condition to transact business,” according to the OTS…

As of June 30, WaMu had more than 43,000 employees, more than 2,200 branch offices in 15 states, and $188.3 billion in deposits, according to the OTS.

In other words, WaMu lost 9% of its deposit base since September 15. While some of that may have been insured depositors who were unreasonably spooked (or who feared a temporary interruption in account access due to a reorganization of WaMu) it’s likely that run was driven by uninsured depositors who feared actual loss of principal.

Raising the Limit

With the obliteration of standalone investment banks, one key advantage that commercial banks have touted is a stable deposit base. However, as the WaMu case shows, a deposit base is not necessarily stable. The government could make deposit bases more stable by eliminating or greatly increasing the FDIC insurance limit, so no or few depositors would be motivated to flee troubled banks.

Given this, I’m surprised that an increase in the FDIC insurance limit hasn’t been a part of the national conversation about saving the finance industry. Why is raising the limit unappealing? Of course, a higher insurance limit would make bank failures more expensive for the FDIC. However:

  1. It’s obvious that the government is going to spend money on fixing the banking crisis in one way or another;
  2. The FDIC could raise insurance premiums to offset part or all of the added costs;
  3. In many cases, the FDIC ends up covering uninsured deposits voluntarily, so it’s already incurring the costs without the benefit of greater depositor confidence; and,
  4. If higher insurance limits result in fewer bank failures, the policy might save the FDIC money.

Point (4) is the $700 billion dollar question about raising the insurance cap. Could WaMu have survived if depositors, knowing they were insured, had little reason to flee the bank? Or would a more placid deposit base have only delayed an inevitable collapse due to the ultimate cause of WaMu’s weakness—bad mortgage assets?

Of course, another reason to keep a low FDIC limit is to provide market pressure on banks to maintain stable asset portfolios; it banks can draw depositors whether or not they are responsible, banks are less incented to behave responsibly. But given today’s situation, where the government is trying to avoid systemic problems caused by bank failures, I find it hard to believe that an increase in moral hazard from general FDIC insurance would not be offset by the resulting increase in stability.


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