The Behavior of Banks under the Deposit Insurance and Capital Requirements

Compare to other firms, banks are special in three ways. First, most banks are insured by deposit insurance. Second, banking industry is highly regulated. Third, banks are financial intermediary. To attract deposits is one of a bank’s main functions, and deposits compose the most part of a bank’s debt. Among the various regulations, minimum capital requirements play an important role, which require banks to keep their capital-to-asset ratio above a certain amount. Usually the minimum capital requirements are considered as a remedy of the deposit insurance. In banking system, deposit insurance can be purchased from the governmental insurance agency–the Federal Deposit Insurance Corporation(FDIC). Although banks are not commanded to join the FDIC, most banks have the membership. In the beginning of the FDIC history, member banks obtained full coverage on deposit at a quite low premium. Later, the effective premium increased while coverage were cut down, however, the premium explicitly paid was still ignorable compared to the big amount of deposit coverage. After risk-based premium system was originally established, 75% banks were in the best-rated category. This percentage of best-rated banks increased to 93% in 2000. These best-rated banks pay no premium for deposit insurance. It should not be surprising if banks take advantage of this ”generous” insurance system. According to moral hazard theory, an insurant tends to be less careful about their risky behavior since he can leave the loss to the insurer. This moral hazard behavior is often seen especially when insurance is not correctly priced. Under the protection of the FDIC, banks have incentive to take deposits as much as they can for some debt-favor reasons such as tax deduction on interest payment, and let the FDIC pay for the deposits if it turns out banks do not have enough capital to pay the deposits back. As a matter of fact, the average bank capital ratio had decreased from 13% to 6% during the first decade after deposit insurance became effective. However, the capital ratio had begun to fall steadily from more than 50% since 1840, long time before the FDIC was established. This casts some doubts on the criticism of the deposit insurance. 1970s witnessed another mild decrease in capital ratio of banks in the U.S. Meanwhile, the number of failed banks rose slightly. In 1981 the regulator, for the first time, implemented explicit capital requirements in hope of preventing bank crisis. They required all the