Expanding FDIC Insurance Could Lead to More Bank Failures by Creating ‘Moral Hazard’

Proposals to expand the federal deposit insurance program to protect more customer funds could actually lead to more bank failures, a panel of industry experts told lawmakers Thursday.

U.S. lawmakers are thinking about expanding insurance provided by the Federal Deposit Insurance Corp. as part of a swath of efforts to protect accountholders in the wake of three major bank failures earlier this year.

But some experts say the changes would encourage banks to engage in even riskier behavior, giving rise to "moral hazard."

“Any significant changes to the deposit insurance status quo could actually engender more harm than good by incentivizing risk taking by banks,” Emily DiVito, of economic think tank the Roosevelt Institute, testified before the Senate Banking Committee.

Currently, the first $250,000 of deposits in certain accounts at federally insured banks are covered. That means, if a bank fails and deposits are wiped out, the government will reimburse up to $250,000 in losses for individual accountholders. The system is meant to put eligible bank customers at ease and prevent a run on deposits during turbulent times.

But the failure of three banks this year — starting with Silicon Valley Bank in March where about 90% of accounts were uninsured — is prompting policymakers to reevaluate the rules. The current deposit insurance regime wasn’t enough to prevent customers from yanking $42 billion out of SVB in less than a day, lawmakers said, so they’re thinking about raising the cap on FDIC insurance to give account-holders more peace-of-mind.

The panel of experts examined three possible changes, universal and unlimited government coverage for all bank accounts, expanded coverage for some accounts, or leave the current system in place.

The first two possible changes would fuel ‘moral hazard,’ which is when private companies take on more risk because they assume the government will bail them out, according to the panel.

This could lead to "additional bank failures and larger losses," Andrew Olmem, a partner at Mayer Brown LLP, told the committee.

Thomas Fraser, the CEO of Ohio-based First Mutual Holding Company, told lawmakers any changes to FDIC insurance "must rigorously assess unintended consequences of making policy changes."

DiVito said that government efforts focused on “strengthening our institutions and regulatory environment” such as higher capital and liquidity requirements for banks paired with a higher insurance cap could protect depositors even better.

Olmem said there were limits to what could be done with FDIC insurance. "Although deposit insurance can greatly enhance the resilience of the banking system by reducing the risk of runs and mitigating the costs and spillover effects of bank failures, it cannot address all financial risks nor forestall on its own all financial crises," he said.