A Guide to Deposit Insurance Reform

Deposit insurance was introduced in the United States during the Great Depression primarily to promote financial stability. Stability is enhanced because deposit insurance reduces the likelihood of a bank run. During its first four decades, deposit insurance appeared to work well as few banks failed. But in the 1980s, a wave of financial troubles in the banking and thrift industry exposed an unfortunate side of deposit insurance—moral hazard. In other words, deposit insurance encouraged undercapitalized depository institutions to take excessive risk. The crisis in the 1980s was most acute for thrifts because they were functioning with very little capital. A large number of thrifts failed depleting the insurance fund and necessitating a taxpayer bailout. The bank insurance fund was severely reduced as a result of bank failures. Extensive reforms in 1991 were designed to prevent a recurrence of such problems. The Federal Deposit Insurance Corporation Improvement Act, or FDICIA, focuses on preventing moral hazard, which many observers claim was a major cause of the crisis. Today’s banking system is not in crisis. In fact, most banks are doing well. Still, both houses of Congress are debating new ways to reform deposit insurance. The view of many in the banking industry is that cur-