Ryan Gardner

Econ-2020
Professor: Dennis Wilson
Date: 11/9/16
Federal Deposit Insurance Corporation and Moral Hazard

As a young child growing up I was always asking the question, why? My parents tried
to teach me responsibility from a young age, so when I was old enough to earn an allowance for
doing chores around the house, they insisted that I open a bank account to deposit and save a
portion of my allowance. Being the inquisitive child that I was, I automatically asked, why?
My mother patiently explained to me that it is a safe place to keep my money because the bank
locks the money in big vaults. I asked, What happens if a bank robber steals my money? My
mother quickly responded by explaining that the money is insured by the government, and I will
get it back. This didnt make much sense to me at the time, but luckily, I didnt stop asking the
question, why?, and eventually this question led me to the issue of moral hazard and the FDIC.
Before I discuss why moral hazard is an inherent problem with FDIC insurance, I will first
describe historical banking practices and how they evolved into the banking system that we have
in the United States today. I will then discuss the history of the FDIC insurance program, why it
was created, and how it operates today. I will continue the discussion by outlining the moral
hazard that exists, and look at the causes of the recent bank failures, then compare their causes
with the moral hazard of FDIC insurance. I will then discuss the misallocation of resources that
is caused by this moral hazard, and the effect it has on the aggregate economy.
Historically, gold was the widely-accepted form of money among many ancient
civilizations. Gold was the standard for money for a couple of reasons. Gold is scarce enough

that it can be a store of wealth, yet abundant enough to meet the needs of ancient economies. The
story of the origin of our banking system lies in the pitfalls of gold as money. The first problem
was the inconvenience of gold; gold is heavy and had to be checked for purity during
transactions. The second problem is that someone could easily rob you of your entire net worth,
and once the gold is gone, there is probably not much chance of recovery unless authorities can
physically find the robber.
The natural solution was to rent vault space from the goldsmith, who also keeps their own
gold in their vault, so you know it will be protected as if it was their own. The goldsmith was
also able to solve the inconvenience of carrying around a heavy sack of coins. Being the
goldsmith, authenticating the coins was already his specialty. It was later figured out that
certificates could be issued in the place of gold. In the book, The Creature from Jekyll Island,
Edward Griffin explains the transition from a vault rental to something that more closely
resembles modern banking. He says, When the coins were placed into the vault, the
warehouseman would give the owner a written receipt which entitled him to withdraw at any
time. At first, the only way the coins could be taken from the vault was for the owner to
personally present the receipt. Eventually, however, it became customary for the owner to merely
endorse his receipt to a third party who, upon presentation, could make the withdrawal. The
issuance of a certificate endorsed by the owner would be the modern equivalent of a check.
The goldsmith eventually made the realization that he only needed enough money to
cover normal withdrawals, and he could make a profit by loaning out the reserves. This was
obviously unacceptable to the owners of the gold, and they demanded a cut of the earnings, and
the goldsmith transitioned from depositors paying him for vault space, to him paying depositors
to allow him to use their money. It wasnt long after that a rumor started that the goldsmith did
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not have any gold in his safe at all, and once fear and emotion took hold all depositors requested
their reserves back from the goldsmith. Since the goldsmith was only keeping a portion of the
deposits, and loaning the rest of the gold out, he could not make good on his promise, and the
small bank became insolvent.
The reason the story of the goldsmith is relevant, is because it is analogous of the bank
runs that occurred in the 1920s and 1930s. The FDIC website states that, The FDIC was
created in 1933 in response to the thousands of bank failures that occurred in the 1920s and early
1930s. The creation of the FDIC was a response to the panic that overcame the public, and was
created to restore peoples confidence that their money will be available when they need it. The
principle behind the FDIC insurance is similar to other types of insurance; the banks pay a
premium to the FDIC which funds the FDIC reserve, which is used in the event of a bank failure
to pay back the depositors.
The FDIC website says that the fund is supposed to have a reserve ratio of 1.35% of all
insured deposits by the year 2020, and there is currently $54.3 billion in the fund. (FDIC) So we
are back to the fundamental question of, how does this small fund insure against a run on the
banks such as in the 1920s and 1930s? It appears to operate under the same fundamentals as the
fractional reserve banks do. It is relying on a lower demand for funds than is in reserve. This
small reserve fund of 1.35% of all insured deposits clearly does not provide enough capital to
refund depositors in the event of a bank run. This fund is not the last line of defense though, Ana
Gonzalez Ribeiro clarifies this in her article, Who Backs Up The FDIC? by explaining, If the
DIF (deposit insurance fund) were to be depleted, the FDIC also has a $30 billion line of
credit with the Department of Treasury and the federal government's guarantee that if the FDIC
exhausts its other options, the government will step in to provide further financial backing. The
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FDIC could also borrow money from the Treasury in the form of short-term loans. This occurred
during the savings & loan crisis in 1991, when the FDIC was forced to borrow several billion
dollars from the Treasury. To me it appears that the FDIC policy is one of reassurance, and
relies on the prevention of bank runs by increasing public trust, rather than actually having a
system to handle a real bank run such as that in the 1920s and 1930s. Now that we have enough
information about the history and inner workings of the system, we can begin to assess the
problem.
The inherent moral hazard associated with the FDIC can be broken down into several
parts, with competition between banks being the catalyst. Like other businesses, the main
objective of a bank is to stay in business and make a profit. Banking is a competitive industry,
and the threat of going out of business drives up the amount of risk that a firm is willing to take
on. Each FDIC insured bank is required to pay into the insurance fund, which guarantees their
deposits. The banks now know that depositors are covered if they take on heavy losses, so in
order to get their monies worth on their insurance premium, they have incentive to invest into
risky assets with high potential returns. When those poor investments go bottom up the bank
goes bust, the creditor takes on the losses, and the depositor is refunded, right? Not if the failure
is systemic, and all of the nations banks are exposed to the same toxic assets. When the entire
United States economy is at stake, the Federal Government is inclined to step in with bailout
packages, ultimately putting the tax payer on the hook for funding. The sense of security in the
banking industry allowed them to take on too much risk prior to 2008, and they knew that they
would not be allowed to fail. So, what is designed as insurance against failure of banks is now
something closer to a guarantee of failure.

Willam Poole offers a resolution in his article, Moral Hazard: The Long-Lasting Legacy
of Bailouts. He said, The only resolutional procedure that will control moral hazard is one in
which some creditors will take a hit if a large firm fails. Wiping out shareholders is not enough
creditors of these highly leveraged firms must be at risk. Poole understands that the economy as
a whole can be badly damaged by the misallocation of resources by banks that are not held liable
for their mistakes. Poole continues by saying, The booms led to excessive allocation of capital
to the dot-com companies and to housing. The physical waste of resources was staggering:
Thousands of miles of excess fiber-optic cable should never have been laid and thousands of
houses should never have been built. These capital investments had a much lower rate of return
than expected, which meant that the financial instruments issued to finance them fell far below
their par values. The mortgage boom left us with not only too much housing but also insolvent
households that had extracted equity from their properties and used the funds for consumption.
These examples of the effects of misallocated resources should hit close to home for those who
experienced the great recession of 2008.
In conclusion, the creation of FDIC insurance appears to be well intentioned, but has had
unintended consequences that have led to the complacency of banks. FDIC insurance
incentivizes banks to operate at minimum reserve ratios in order to get the best return on their
FDIC insurance policy. Operating at low reserve ratios combined with the complacency of
investment selection in search of the highest possible return has caused misallocation of
resources in our economy. In order for a market system to function normally, the bad players
must be allowed to fail. The failure of bad firms allows those resources to be reallocated to more
productive uses, allowing for greater growth of the economy and higher living standards for the
people. The FDIC certainly isnt the only factor relating to the poor footing banks have gotten
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themselves into with their portfolios in the past, but an overall adjustment of policy is needed.
Executives that mismanaged and caused the failure need to be wiped out in the event of failure.
Stakeholders who applied the pressure to executives for maximum returns need to be wiped out
in the event of failure, and only the parties who had no fault, such as the depositors, are refunded.
I believe that the adjustment of policy to get rid of these bad incentives are a necessary step
toward preventing future failures in the banking system. It is my belief that policy should be
focused on meaningful prevention of bank failures rather than reacting to the failures.

Works Cited
History of the FDIC. FDIC.gov. Federal Deposit Insurance Corporation. 26 Aug. 2016. Web. 9
Nov. 2016.
Griffin, Edward. The Creature from Jekyll Island. Westlake Village: American Media, 2002.
Print.
Poole, William. Moral Hazard: The Long Lasting Legacy of Bailouts Financial Analysts
Journal: pg. 17-23. Web. 9 Nov. 2016
Gonzalez Ribeiro, Ana. Who Backs up the FDIC? Investopedia.com. Investopedia.
Web. 9 Nov. 2016