Deposit Insurance Reform: Is It Déjà Vu All Over Again?

When Congress goes back to work, deposit insurance reform will once again be on the agenda. Although the bills considered in the last session would change the program in several ways, no proposed change has sparked more controversy than hiking the coverage ceiling to $130,000 per account from $100,000.

Among the proponents of a higher coverage ceiling are community bankers. During the '90s, large banks merged at a record pace—realizing sizable efficiency gains and putting intense cost pressure on smaller institutions. At the same time, community banks lost consumer loans and retail deposits to tax-exempt credit unions.

Community bankers argue that a higher ceiling would give them a better shot at luring large household deposits, retirement accounts and municipal deposits away from larger banks. These bankers contend that raising the ceiling is only fair because:

• large banks have traditionally enjoyed "too-big-to-fail" status, which effectively extends coverage to all deposits; and
• inflation has eroded the real value of coverage considerably since 1980—to compensate for 22 years of inflation, the ceiling would have to rise to $218,000.

Opponents of a higher coverage ceiling argue a different point: Raising the deposit insurance ceiling could encourage banks to take more risks. Increased deposit insurance allows risk-taking banks to draw incrementally more heavily on funding that carries little or no interest premium or penalty for excessive risk taking. In turn, the higher risk could put the taxpayers—who ultimately stand behind the program—at a greater chance of loss. Opponents point to the thrift debacle that followed the last increase in the coverage ceiling, which occurred in 1980.

There are several reasons why we feel the current deposit insurance ceiling needs to be maintained:

• First, the current ceiling already provides much more than $100,000 in coverage. For example, by using joint and multiple individual accounts, a family of four can insure up to $3.2 million at a single institution.
• Second, the case for inflation indexing depends on the base year chosen. If the starting point is the 1935 ceiling ($5,000), rather than the 1980 ceiling ($100,000,) the current cap should be reduced to $65,954.
• Finally, if subsidies to large banks and credit unions put community banks at a competitive disadvantage, it might be better to eliminate those subsidies rather than introduce more distortions.

Many economists and policy-makers warn that theory and experience argue against boosting the coverage ceiling, and they suggest a cautious approach. As Yogi Berra phrased George Santayana's warnings about the lessons of history—it may be déjà vu all over again.

A longer version of this essay appears in the October 2002 edition of The Regional Economist.