Deposit Insurance

The Need for Deposit Insurance

Virtually all countries have deposit insurance these days, although for most of the history of banking the public were left unprotected, leading to much loss when things went the wrong way.

People protect many different things in their life with insurance, and all of them have a financial basis. This is what insurance does, it compensates you when you suffer a financial loss. So if an insured event happens, you submit a claim to an insurance company that you’ve been paying premiums to in order to protect you against this event, and you receive monetary compensation for it.

The idea here is to protect against events that would leave you in a state of financial hardship if it happened, and losing the money you have on deposit at a bank certainly qualifies as a potential financial hardship. People can and have lost their entire life savings through bank failures, which is a hardship indeed.

Many people have all their money on deposit at a bank, and often at a single bank, where they have essentially loaned their money to the bank on the promise that it will be paid back when they request it to be. So there is a lot of potential risk involved in this which must be properly managed, and when you take into account that bank failures involve a lot of depositors and a lot of money, the impact can be a great one indeed.

This is Too Important to be Left to Chance

Deposit InsuranceOther financial hazards are protected against by commercial insurance companies, where one purchases certain types and certain amounts of coverage as their particular situation and means dictate. Deposit insurance is so important though that governments handle the entire affair themselves, protecting everyone fully up to a certain stated amount of coverage, which is generally a large enough sum to take the sting out of the losses one would incur.

So you may not get everything back, but if you get back enough so that you aren’t hurt too badly by a bank failure, that’s the goal of the insurance scheme, to not leave people out in the cold completely.

Now the amount of money that you are left with may not be sufficient for your purposes, for instance if you had a million dollars saved that you will need in retirement and have lost most of it this is going to affect you quite a bit, but at least you won’t be wondering how you’re going to pay your bills or how you are going to get by, and that’s the goal really.

Depending on where you live, deposit insurance may cover you to the maximum amount with more than one type of account, a single account might provide the maximum coverage and a joint account may provide an additional amount, as well as other types of accounts and accounts at other banks potentially providing additional coverage.

Perhaps the best way to spread the risk around is to have your money spread across several banks, and even if you don’t get additional coverage this way, if you have all your eggs in one basket, it’s more likely you will face losses then if you spread it out among several, where it’s less or even a lot less likely that several will fail at the same time.

If we ever had systemic bank failure like that then people are in big trouble anyway, and whether a government could handle such a thing is an open question, but this would lead to financial collapse anyway, with very dire consequences. Fortunately, banking is well regulated these days and even in the earlier days of banking without any real regulation, the market only claimed a fairly small percentage of banks as victims of failure at any given time.

The Fragility of Banks

Banks portray themselves as bastions of stability, but in a way this is like an animal puffing up to make themselves look bigger, as banks are actually extremely fragile when left to their own resources.

What happens with deposits is that they take your money and lend it out, and in order to stay in business, they need people to keep their money with them, or they need protection from outside the bank to ensure they can continue to meet their obligations if more people want their money back.

This would be a very precarious situation and many banks have been brought down simply because a higher percentage of deposits have been withdrawn. Contrary to what some people think, the bank doesn’t keep your money in their safe waiting for you to take it out, it’s loaned out with terms generally running several years.

So your money will return to the bank, but over longer periods of time. You want it now though, and they do keep a small percentage of their deposits on hand to cover withdrawal requests, but if too many people want to withdraw, then they may have to close down at least temporarily so they can figure out how they are going to handle this.

Even things like long lines have set people panicking and once the panic starts, then things can get really bad, as this puts even more pressure on the bank to come up with money they don’t have. A bank run may result and bank runs have put many banks out of business, and is by far the leading cause of death with banks historically.

This is far less of a risk with today’s banks though, although it still can be a concern. Nowadays we have central banks stepping in to allow banks to manage their day to day access to funds, and provided that the bank is sound financially, they can borrow the money from other banks, or from the central bank if they can’t raise enough funds that way, and this is why the central bank is called the lender of last resort.

So the potential for bank failure today is much more a matter of their business operations being profitable, although some banks do take on more risk than they should, as was the case with Washington Mutual a few years ago. They ended up being a victim of the subprime mortgage crisis in 2008 which caused them to go bankrupt and have their assets seized by the government.

So if there’s a run on a bank, and there certainly was one on this bank, if the bank is stable enough financially to weather the storm, then they can borrow, but if not, this can indeed lead to bank failure.

These days, factors that determine financial stability for a bank are considered to be what is really important, much more so than the percentage of deposits that they have on hand, and some countries don’t even require them to keep a minimum percentage of deposits on hand, so long as they have the assets in place to handle things and these assets are stable enough and not exposed to too much risk.

The Government Really Has Your Back With Deposit Insurance

So governments, through both central banks and deposit insurance, use a two pronged approach to managing the risk of bank failure. They lend to them as needed provided they merit it, and when they do not and get in trouble, they provide insurance to depositors.

While premiums are collected from banks and remitted to the deposit insurance organization, these premiums are essentially passed along to depositors indirectly, for instance they could pay you a bit more interest if not for these deposit insurance premiums.

However, the cost is very low and well worth it, and the reason why the cost is so low is that governments go to such great lengths to protect the health of the banking system. If not for this, then it would cost a lot more for this insurance because the risk would be a lot higher.

It’s not even that the main concern here is insuring deposits, even though that does matter a lot. It’s actually more important that people have enough confidence in the banking system such that they continue to deposit without worry, so the biggest risk here is that people will perceive too much risk. So it’s essential that this risk be kept to a minimum.

It’s not even a matter of their not depositing more, it’s more a matter of their taking out too much, and if they did, this again could cause the entire economy of a country to collapse, and depending on the country, perhaps even the entire world economy to collapse.

So with the potential for truly devastating consequences, governments are going to work much harder at protecting your money than if it was just you and other depositors losing money, which would be unfortunate but much less significant.

So deposits are overprotected in this sense, and the idea that the larger banks anyway are too big to fail has to do with the fact that they actually are, because the consequences to the overall economy would not be acceptable at all.

Even so, it is still wise to look to diversify here, not only among banks but among different classes of investments, if one has enough wealth that deposit insurance only allows for partial protection. If one really wants to hedge against widespread risk here, then things like gold can be a good hedge against this, and this is a strategy that many people use.

The idea with risk management and hedging is not to necessarily not be left in a worse position, it’s not to be left in a position that is unacceptably worse, and this is exactly what insurance is designed to do actually. So deposit insurance, like all insurance, serves to provide us with a means of avoiding losses too large and consequences too great.



Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

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Topics of interest: News & updates from the Federal Deposit Insurance Corporation, Retirement, Insurance, Mortgage & more.