Quote of the Day: The FDIC’s very paltry defense against defaults

Since then, FDIC recovered a bit, and as of 2013 had $47 billion back in its fund. This small defense was insuring some $6 trillion in insured bank deposits, a coverage ratio of 0.79 percent.

Now when I brought up this alarming situation at my personal blog, some people scoffed in the comments. Why, if there is ever another wave of bank failures, the FDIC can just borrow from the Treasury. Ultimately, the government can just turn to the Federal Reserve to create new money and make everybody whole. Now that we’ve gotten rid of that pesky gold standard, Uncle Sam can hand out unlimited amounts of dollars.

Such a reaction is shocking in its glibness. Remember that FDIC is supposed to be an insurance program. It doesn’t get its fund from taxpayers, but from premiums assessed on the insured banks themselves. Indeed, in order to replenish its fund, back in 2009 FDIC made the banks “prepay” thirteen quarters (i.e. a little more than three years) worth of premium payments. Once the immediate danger was past, FDIC issued refunds of these overpayments in 2013.

Nobody doubts that the government has the technical ability to create billions or even trillions of dollars and hand them out. But that isn’t a way for society as a whole to become richer. Yes, if a small number of depositors lose money on a few failed banks, then the rest of us can—via the government—act as a backstop, and spread the losses around, so that any individual feels just a slight amount of pain.

Yet having government-imposed deposit insurance makes the system as a whole far more vulnerable, particularly when the banks are being assessed such low premiums (in normal times). Precisely because people think, “My money is 100% guaranteed in the bank,” nobody ever does research on what exactly his or her bank does with the funds it lends out. People care about monthly fees, branch hours, and ATM locations, but they don’t ever inquire, “Does my bank make wise investments?”

FDIC as implemented thus gives us the worst of both worlds: It lulls depositors into a false sense of security, so that there is little market discipline reining in reckless lending by the banks. Yet at the same time, given that the system is pushed to embrace risk, FDIC nonetheless carries a very paltry defense against defaults. In the event of a major downturn, the government would have to freshly dip into taxpayers in order to take money from us, so that it could give us our money back.

(bold mine, italics original)

This is from Austrian economist, consultant and author Robert P Murphy at the Libertychat.com. 

The above is a noteworthy example where centralization of a complex process via political interventions, particularly applied to the US banking system, increases systemic risks. That's because such actions skews on the market's incentives to self regulate via the promotion of depositors' dependency on political authorities, as well as to advance the Moral Hazard incentives of the banking industry.

This also shows of the knowledge problem of political authorities who seem to underestimate the risks from the current system, or alternatively, appears to overestimate the strength of the banking system or the FDIC's capacity to contain risks.  And this may be aside from the possible "regulatory capture" where the banking industry may have influenced authorities on the "low premiums" for maintaining a tenuously funded politically controlled centralized deposit insurance. All these and more combine to produce "the paltry defense against default".