Deposit Insurance Is Not Free

December 11, 2012

Government-provided deposit insurance has been touted as a costless solution to the problem of bank runs. However, it is important to remember the popular phrase that "there is no such thing as a free lunch," say William J. Luther, assistant professor of economics at Kenyon College, and Thomas L. Hogan, an assistant professor of economics at West Texas A&M University.

Bank runs are caused when individuals that have deposited money into banks withdraw their funds before a bank is able to generate a return on those deposits. Those deposits are necessary for banks to make investments in productive ventures.  Banks can have people withdraw early, as long as the bank is able to cover all its commitments to depositors.

The problem comes in when the fraction of early withdrawals exceeds a crucial level, creating a snowball effect in which depositors that would otherwise keep their money in the banks end up withdrawing early. This causes the bank to become insolvent.

An article by Douglas W. Diamond and Philip H. Dybvig argues that since a government can raise revenue at any time, they can place a tax on depositors that withdraw their funds early. In this case, either the tax can be used to fund the bank to prevent insolvency or depositors are deterred from withdrawing their funds in the first place. They posit that this method means the government-provided deposit insurance can be provided at no cost.

However, deposit insurance is a costly solution in which the government has to expend real resources, say Luther and Hogan.

  • Total expenses for the Federal Deposit Insurance Corporation's (FDIC) Deposit Insurance Fund have averaged $2.67 billion each year.
  • In total, that is almost $208.33 billion since 1934.
  • Of all the total expenses, administrative and operating expenses are $32.15 billion (15.43 percent) while net disbursements to depositors of failed or assisted banks total $256.86 billion (75.29 percent).
  • Administrative and operating expenses have also been on the rise because of increases in population and real per-capita wealth.
  • The amount that is covered by the FDIC was just $40,168 in 1934 (inflation-adjusted), whereas in 2011 that figured ballooned to $239,234.

Source: William J. Luther and Thomas L. Hogan, "Deposit Insurance Is Not Free," Mercatus Center, December 4, 2012.


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