FDIC Insurance and Moral Hazard

Here is a picture of Lucas. I apologize in advance. I swore I wouldn't let Wayne post again after the last disaster, but alas here is his latest rant. Sorry! :)


The results of the federal government’s “stress tests” are in (link), and 10 of the nation’s 19 largest banks need a total of about $75 billion in new capital to withstand losses if the recession gets worse. One of the institutions that failed the test was Bank of America, which the government estimates needs $34 million in new capital. Bank of America also happens to be where Portia and I do the majority of our banking.

It could be worse for Bank of America. Wells Fargo, for example, needs between $13 and $15 billion in new capital to stay afloat. Still, the numbers show Bank of America is in bad shape and may not survive the recession. Armed with this information and motivated by fear of losing their savings if their bank goes under, one might expect the customers of these failing banks to withdraw all their deposits. However, a run on banks is not, and almost certainly will not, happen.

But what keeps patrons from pulling all their cash out of these insolvent banks? Why don’t Portia and I withdraw all our money from Bank of America and put it instead in JPMorgan Chase, a bank deemed by the government not to need new capital? Two words: moral hazard. Moral hazard is the idea that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

Faced with the prospect of losing their money, most people would withdraw all their deposits from a bank with a significant chance of failing. However, because of FDIC insurance, all customers of these failing banks are insulated from the risk of losing their savings. Thus, protection from risk has caused consumers to behave differently than would be expected if they were to realize the full risk associated with patronizing a failing bank.

This becomes a problem because it serves to keep poorly run banks afloat. Free market enterprise is survival of the fittest, and we are all better off when bad firms fail and good firms succeed. There is a reason Bank of America is in bad shape right now. It was poorly managed, took on excessive risk, and made bad investments. FDIC insurance was created during the banking crisis of the Great Depression to protect consumers from losing their deposits. However, what it had done is protected banks from being responsible to the people that make them profitable, their customers.