Deposit Insurance

The U.S. savings and loan crisis of the 1980s was caused by deposit insurance. Imagine that I was the type of person who liked to make very risky and sometimes silly investments. Would you be willing to lend me money? Now imagine that the government promised to repay your loan to me if I couldn’t repay. This governmental guarantee would mean that you wouldn’t have to worry about my solvency. With the guarantee, you could feel comfortable lending me money, even if you knew that I would squander it.

Savings accounts in U.S. banks are guaranteed by federal deposit insurance. When you put your money in a savings account, the bank uses it to finance investments. If these investments go bad, the bank might not have the funds to give you back your money. Because of deposit insurance, however, the government guarantees to pay depositors of insolvent banks. Consequently, deposit insurance allows banks to attract depositors even if the bank makes extremely risky investments.

Imagine you were about to go gambling and a rich friend promised to pay any of your losses. If you won $10,000, you could keep the money. If you lost $15,000, your friend would compensate you for your loss so you would break even. Your friend’s guarantee would create incentive for you to take massive risks. You should bet everything you have because if you win, you win big, whereas if you lose, you always break even.

Deposit insurance causes banks to take risks because it guarantees that at worst depositors break even. Consequently, banks have incentives to take depositors’ money and make huge gambles. If the investments pay off, everyone gets rich. If they fail, the taxpayers pay.

To combat the ills of deposit insurance, the federal government must constantly monitor banks to ensure that they don’t make overly risky investments. Sometimes, however, federal oversight fails, as it did in the savings and loan crisis. In this crisis savings and loan institutions made risky real estate gambles and lost, costing U.S. taxpayers billions.