Deposit Insurance Is Not Free

Deposit Insurance Is Not Free
December 14, 2012

Economists are apt to point out there is no such thing as a free lunch: Someone has to pick up the tab. Surprisingly, one common justification for government-provided deposit insurance maintains that it is a free lunch, that no one has to pay for it.

Contrary to theoretical arguments, deposit insurance is not free in practice.

In their influential 1983 article “Bank Runs, Deposit Insurance, and Liquidity,” Douglas W. Diamond and Philip H. Dybvig defend government-provided deposit insurance as a costless solution to the problem of bank runs.

Unlike a private bank, they note, a government can raise revenue at any time through taxes. If a bank run occurs, the government can tax those impatient depositors who withdrew their deposits early and use the money to ensure patient depositors are paid. The fact that patient depositors will be paid even in the case of a run removes their incentive to run in the first place.

As a result, bank runs do not occur, and the government need not pay any depositors. In the model, the mere commitment to pay depositors in the case of a bank run is sufficient to prevent bank runs. Hence, Diamond and Dybvig conclude government-provided deposit insurance can be provided at no cost.

Practice Different From Theory

Following Diamond and Dybvig, many economists have come to see government-provided deposit insurance as a free lunch. Their original article has garnered more than 1,000 citations in academic journals, is listed among the 25 most influential articles in economics, and forms the basis of discussion on deposit insurance at the undergraduate and graduate level.

There is only one problem with the narrative of costless government-provided deposit insurance: Government-provided deposit insurance in practice differs significantly from that proposed in theory.

In practice, government-provided deposit insurance is not a costless solution. The government must expend real resources to provide deposit insurance. Total expenses for the FDIC’s Deposit Insurance Fund have averaged $2.67 billion each year since its inception. A total of $208.33 billion has been spent to date—with more than half (51.37 percent) of all expenses incurred in the last 10 years.

More than 90 percent of the cost of deposit insurance can be explained by two factors: (1) administrative and operating expenses and (2) net disbursements to depositors of failed or assisted banks. Administrative and operating expenses total $32.15 billion (15.43 percent of total expenses). Net disbursements total $156.86 billion (75.29 percent of total expenses).

Accelerating Expenses

Administrative and operating expenses have been growing rapidly in recent years. From 1934 to 1974, they grew at an average annual rate of 1.24 percent, averaging just $0.12 billion per year over the period. Administrative and operating expenses grew at an average annual rate of 4.85 percent from 1974 to 2011. In 2011, annual administrative and operating expenses totaled $1.56 billion.

Why are administrative and operating expenses on the rise? Part of the growth can be explained by increases in population and real per-capita wealth. Total domestic deposits held in FDIC-insured institutions increased from $643.66 billion in 1934 to $8,401.23 billion in 2011.

Additionally, the maximum amount covered under the FDIC has increased during the period. Congress has raised the nominal maximum amount covered by FDIC insurance seven times since its inception. In 1934, the inflation-adjusted maximum amount covered under the FDIC was $40,168; FDIC-insured deposits totaled $290.42 billion and roughly 45 percent of all domestic deposits held in insured banks were covered. In 2011, the maximum amount covered under the FDIC was $239,234; FDIC-insured deposits totaled $6,678.59 billion and around 79 percent of domestic deposits held in insured banks were covered.

These figures suggest that as the size of the fund increases, the costs of administering the fund similarly rise.

Costs of Assistance

The biggest cost of government-provided deposit insurance is disbursements to the deposit holders of failed or assisted banks. When a bank fails, the FDIC pays its insured depositors out of the Deposit Insurance Fund and recovers any remaining assets. Net disbursements equal total disbursements less the value of assets recovered.

Net disbursements vary significantly from year to year. Whereas annual net disbursements average $2.01 billion, the median is only $0.04 billion. Indeed, the bulk of disbursements (96 percent) are clustered in just two periods: the savings and loan crisis (1981–1994) and the financial crisis (2007–2011).

During the savings and loan crisis, 1,464 banks closed, at an average rate of 9.38 banks per month. Net disbursements averaged $4.72 billion per year over the period—ranging from $12.59 billion in 1988 to $0.26 billion in 1994. Each bank failure resulted in an average net disbursement of $0.04 billion.

In the most recent financial crisis, 414 banks failed, at an average rate of 8.63 per month. Net disbursements were significantly higher from 2007 to 2011. Roughly $22.31 billion was disbursed each year on net—more than $0.21 billion for each failed bank.

Contrary to the view put forward by Diamond and Dybvig, government-provided deposit insurance is not free.

William J. Luther (lutherw@kenyon.edu) is an assistant professor of economics at Kenyon College in Gambler, Ohio. Thomas L. Hogan (thogan@wtamu.edu) is an assistant professor of economics at West Texas A&M University. Excerpted with permission from their Mercatus Center of George Mason University paper, Deposit Insurance Is Not Free.