Most people think of the FDIC as a the friendly Federal agency that insures your money if your bank goes belly up.  You can stash your money away safely, up to $250,000, and not worry about it because if anything happens, the FDIC will be there if things go bad.

That's how the fairy tale begins.

The FDIC was created to protect savings accounts and prevent bank runs.  This was a big problem in the Great Depression from 1929 to 1933, as depositors besieged their banks all at once, forcing some banks into failure because they could not satisfy immediately all their customers' demands.  As one bank went bust, the fear spread through the population, causing more runs, and knocking banks down like dominos.  During this period, about half of all banks were closed.  By insuring accounts, however, depositors could wait for the problem to be resolved, or if not resolved, at least they would get repaid by the government.  For the most part this is what the FDIC did for 80 years.  "Rarely has so much been accomplished a single law," according to JK Galbraith, referring to the establishment of the FDIC.

The end of the line for FDIC

However, the FDIC failed completely in 2008.  The scope of the economic crisis was simply too great.  Banks had hundreds of billions of 'toxic waste' (mortgage-based assets) on their balance sheets, and the FDIC insurance fund (around $50 billion) was far too small to cover the potential losses.  The failure of IndyMac alone (a midsize bank) resulted in a 20% drop of its entire fund.  The FDIC could not handle the failure of many large banks.  (In this sense, the banks were 'too big to fail'.)  As a result, banks received bailouts from the Federal government, including TARP, the Federal Reserve, and indirectly through AIG.  As of today, most of the big banks are 'zombie' banks:  they are technically insolvent, but kept alive by Federal money, Federal support of mortgage-backed securities (which temporarily inflate asset prices on the balance sheets), and the implicit guarantee of a Federal rescue.  Citigroup is the largest of the zombies, and Bank of America is not far behind.

The Credit Crunch of September 2008 was caused by of the FDIC.  First, this was because banks were hoarding cash for fear that they could be taken over by the FDIC if they fell below their capital requirements (about 6% cash to assets).  Since they did not know the value of some of the 'toxic waste' assets, this was a legitimate fear.  As a result, they did not lend it out as they were supposed to.  Without FDIC regulations, they could have continued lending, albeit at a lower level, to unfreeze the credit markets.  Secondly, investors took huge amounts of cash out of uninsured money markets and the stock market to put into insured FDIC accounts (depositing a record $185 billion in one month).  However, businesses depend on the money markets for short term loans for daily operations, so many businesses were brought to the brink.  Investors used taxpayer-funded insurance to protect their wealth, at the expense of the overall health of the economy.  Perhaps a shrewd move, but it's an abuse of the system.  And yet it is the inevitable result.  Why not insure all your money if you can?

Although it is technically still the banks's regulator, the FDIC is no longer relevant.  Now the Federal government - and the taxpayer - will have to pay when banks finally state their true losses.  Then the banks can be closed or bought buy their smaller, healthier competitors.  Although this will be a painful process, it is necessary medicine.  Only then can a new, sound economic foundation be established.  But as has been shown repeatedly, allowing zombie banks to live only prolongs a recession and increases the final cost (e.g. the S&L Crisis and Japan's 'Lost Decade').

Do we even need deposit insurance?

Deposit insurance was created in 1933 to protect deposits (up to $2500) and prevent bank runs.  However, it is possible to protect deposits in other ways, such as with special bank accounts that invest only in short term government securities.  Bank runs can be prevented by temporarily limiting cash withdrawals.

While it's nice to know that your money is 'safe', it's not fair to expect other taxpayers to insure it.  Furthermore, the insurance is subject to abuse well beyond the original purpose.  Each account is insured up to $250,000, but a person can have as many accounts as they like as long as they are in different banks.  Thus, there is no limit to FDIC insurance.  If a millionaire's bank fails and depletes the FDIC insurance fund, it's the average taxpayer who has to pay them back.

Furthermore, recent research on banking systems across the world has shown that deposit insurance actually makes banking riskier (Rethinking Bank Regulations, Barth, Caprio, & Levine).  Though paradoxical, this actually makes sense.  If we are not monitoring the banks ourselves, knowing that our accounts are insured, they will start to take risks and otherwise behave irresponsibly in the hope of making more money.  Of course government is supposed to regulate and control this.  But banks can generally learn to game the system or 'capture' regulators over time.  Secondly, leaving the government in charge is like putting the fox in charge of the hen house (there are huge conflicts of interest).  Countries where consumers must take some responsibility for monitoring banks have more stable banking systems.

In a further paradox, stricter and more powerful regulation (such as capital and supervisory regulations) also makes the banking system more fragile.  This is partly because the banks cannot operate freely to do what is best for a given situation, and partly because highly regulated banking becomes a political game at the expense of the taxpayer.

The FDIC program must be ended

It is impossible to insure part of the financial system without insuring all of it.  A run on uninsured funds threatens the safety of insured funds.  This has been shown repeatedly in history, as government backed insurance has steadily increased in scope in order to prevent runs.  Even money market funds were federally insured in October 2008, for about a year, to stabilize the markets.  Although this insurance is no longer available, it could be offered again in a future crisis, putting more taxpayer money on the line.  If we continue down this path, the taxpayer will be liable for the entire financial system.

Insurance is not only unnecessary, it is harmful to the banking system.  Individuals must take responsibility for their money. This will force banks to be much more transparent and accountable to their customers, because customers will be monitoring them very closely.  Market discipline is the most important factor in improved bank performance, according to Rethinking Bank Regulations.

There are several things that can be done to protect depositors.  Depositors should be the first in line when a bank fails, in front of bond holders and stock holders.  This will make bond holders think twice before adding leverage to a bank.  Government can take a role in educating consumers on the importance of monitoring their bank and provide references for how to do so.  It can also help insure that banks report their status fully and honestly.   For investors who want 100% safety, they can invest in a US Treasury fund.

We have no guarantees in the stock market.  We have few guarantees when purchasing a home.  We must also assume some risk when putting money in the bank.  We can no longer expect our government to protect us.  The cost to do this is simply too high and it's unfair to pass this cost on to our children in the form of huge deficits.