Risk Based Deposit Insurance

Key Takeaways

• Risk-based deposit insurance uses premiums reflecting a bank's investment prudence.
• It aims to curb reckless behavior and moral hazard in banking.
• The FDIC shifted to risk-based premiums post-1991 reforms.
• FDIC insurance covers up to $250,000 per depositor in member banks.
• Observing banks' risk accurately is essential for effective risk-based insurance.

What Is Risk-Based Deposit Insurance?

How do banks stay accountable when investing your deposits? Risk-based deposit insurance is a safety approach where premiums rise or fall based on a bank's risk profile, which promotes safer behavior and helps protect consumers. It became widely used after the FDIC Improvement Act of 1991 to reduce moral hazard.

Understanding Risk-Based Deposit Insurance

Risk-based deposit insurance became standard after the Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991. During the savings and loan crisis, there was a 28% reduction in the number savings and loans associations between 1980 and 1990, prompting regulators to change tact and switch from a flat-rate deposit insurance system, in which premiums were set at a uniform rate across all banks, to a risk-based assessment arrangement.1

Fast Fact

The FDIC switched to variable risk-based premiums in 1994 for banks and in 1998 for savings institutions.2

The FDIC, an independent federal agency whose primary purpose is to prevent a repeat of the run-on-the-bank scenarios that caused havoc during the Great Depression, uses the deposit insurance premiums it collects from banks to fund the Federal Deposit Insurance program. This program protects consumers by covering deposits of up to $250,000 at member banks in the event that they fail.

Checking accounts, savings accounts, certificates of deposit (CDs), and money market accounts are generally 100% covered by the FDIC, as are cashier's checks and money orders issued by the failed bank. Coverage extends to trust accounts and Individual Retirement Accounts (IRAs) too, but only to the parts that fit the type of accounts listed previously.

Products not protected by FDIC insurance include mutual funds, annuities, life insurance policies, stocks, and bonds, as well as the contents of safe-deposit boxes.

Benefits of Risk-Based Deposit Insurance

Risk-based deposit insurance was designed to stomp out reckless banking and put a stop to moral hazard: a situation in which one party to an agreement engages in risky behavior or fails to act in good faith because it knows the other party bears any consequences of that behavior.

Important

Risk-based deposit insurance is believed to play an important role in preventing banks from failing due to reckless behavior, namely by requiring those with higher risk exposure to pay more expensive insurance premiums.

Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking, which results in them paying more in claims. Risk-based premiums were supposed to discourage such behavior by forcing banks to face the true cost of risk.

Limitations of Risk-Based Deposit Insurance

Risk-based deposit insurance isn’t necessarily a flawless solution to mitigate moral hazard. Its effectiveness hinges on the deposit insurer’s ability to fully observe and comprehend the risk characteristics of a bank’s investment portfolio, a task often riddled with challenges.

It's reasonable to assume that an outsider could struggle to properly evaluate all activities a bank is undertaking and get to grips with the dangers associated with some of its more complicated products. Should this be the case, the premiums charged may not adequately reflect the risk the bank is taking on, potentially leading the risk-based deposit insurance to fail in its mission to control moral hazard.