What if the FDIC Makes Banks More Likely to Fail?

American economist Thomas Sowell is among the leading thinkers of our century. He argued that the FDIC might encourage risk taking at banks.

An AI-generated image of an economist.
Does insurance encourage risk taking?

The U.S. Federal Deposit Insurance Corporation (FDIC) has been a backstop against bank failures since the Great Depression. But what if ensuring banks has actually had the effect of making banks less safe?

"Unless you are well into your nineties or have lived in a country without an established banking system," wrote Sandra Block and Anne Kates Smith in the June 2023 issue of Kiplinger's Personal Finance, "it is highly unlikely you've ever lost money due to a bank failure. Since the Federal Deposit Insurance Corp. was created in 1933, no bank customer has lost a penny in insured deposits, even during the darkest days of the 2008-09 financial crisis."

Block and Smith are, it would seem, seeking to encourage Kiplinger's readers, noting that while "recent bank failures have unnerved savers...your money is protected to certain limits." Those limits are $250,000 per depositor or $500,000 for joint accounts per bank.

Does the FDIC Encourage Risk Taking?

The FDIC is a great source of comfort for folks who banked at Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank —all of which had failed from March to May 2023. But for this short article, let's consider an argument that American economist Thomas Sowell has made, specifically that the FDIC impacts a free market and effectively encourages banks, like SVB, for example, to make investments that are relatively riskier than if they faced more direct scrutiny from depositors.

The idea is simple. When a bank is insured, it becomes a commodity. The depositor knows his money is safe —up to $250,000— so he cares little how the bank lends or invests the money. Banks don't have to compete in the marketplace based on their wise and secure investments. If they fail, like SVB, because of poor money management, their fellow taxpayers bail them out.

"One of the most prominent ways of reducing risk in the United States has been the government's Federal Deposit Insurance Corporation. However, there was state deposit insurance before there was federal deposit insurance," wrote Sowell in his book Basic Economics.

"These state deposit insurance laws were brought on by the increased risks that many states had created by forbidding banks from having branch offices. The purpose of outlawing branch banking was apparently to protect local banks from the competition of bigger and better-known banks headquartered elsewhere. The net effect of such laws made banks more risky because a bank's depositors and borrowers were both concentrated wherever a particular bank's one location might be."

Here Sowell argues that the cause of bank failures in the early part of the 20th century may have been related to state laws requiring all banks to have a single location.

If any calamity hit a small town, its single bank would likely fail.

The FDIC "put an end to ruinous bank runs, but it was solving a problem largely created by other government interventions," wrote Sowell.

"In Canada, not a single bank failed during the period when thousands of American banks were failing, even though the Canadian government did not provide bank deposit insurance during that era," according to Sowell.

"But Canada had ten banks with 3,000 branches from coast to coast. That spread the risks of a given bank among many locations with different economic conditions. Large American banks with numerous branches likewise seldom failed, even during the Great Depression."

The idea is simple, banks were not failing because of the depression only but because they did not have diversified investments. Those banks that could spread risk across regions survived.

Sowell continues.

"Deposit insurance can create risks as well as reducing risk. People who are insured against risks—whether banking risks or risks to automobiles or homes, for example—may engage in more risky behavior than before, now that they have been insured. That is, they might park their car in a rougher neighborhood than they would take it to, if it were not insured against vandalism or theft. Or they might build a home in an area more vulnerable to hurricanes or wildfires than they would live in if they had no financial protection in the event that their home might be destroyed. Financial institutions have even more incentives to engage in risky behavior after having been insured, since riskier investments usually pay higher rates of return than safer investments."

"Government restrictions on the activities of banks insured by the Federal Deposit Insurance Corporation seek to minimize such risky investments. But containing the risk does not make the incentives for risk go away. Moreover, the government can misjudge some of the many risks that come and go, and so leave the taxpayers liable for losses that exceed the money collected from the banks as premiums paid for deposit insurance," Sowell noted.

Is Sowell Right?

Taking away deposit insurance sounds a little crazy to most Americans. But is Sowell right? If we believe in free markets, does something like government-backed deposit insurance incentivize banks to take more risk than is prudent?