Should There Be an Alternative to the FDIC?

The Federal Deposit Insurance Corporation has made saving a worry-free activity for most Americans. I tend to think of the FDIC as one government initiative that has worked quite well for the average citizen. Banks still fail today, but because the FDIC insures deposits and manages the receiverships of failed institutions most depositors lose no money in a bank failure. In fact, often even depositors whose balances exceed what is protected by the FDIC end up not losing any money as the government generally tries to broker deals in which all deposits from a failed institution are transferred to a healthy institution. People can feel confident that their savings really are safe thanks to the FDIC -- a failed bank no longer automatically results in financial failure for numerous depositors.

On the whole, then, I would argue the FDIC does fulfill an important role and does benefit the depositor. However, I think its influence has also been pernicious in other ways. By creating such a secure atmosphere for depositors, the government has reduced competition among the banks. Sure, they still compete on interest rates, customer service, convenience, and product offerings. However, they no longer compete on safety. The incentive to put your money in the steadiest bank has gone away -- your money is protected no matter where you put it, so long as the institution is FDIC insured. I've noticed that banks tend to be anything but transparent. They don't want you to know what they do with your money. They don't want you to know how much money they keep in reserve. They benefit more from the public not knowing how safe their practices are as it takes their fiscal policies out from under the microscope. The less you know about mortgage-backed securities and credit default swaps the better as far as financial institutions are concerned. It has become the business of the government to determine when a bank has been too risky; the depositor can remain strangely unconcerned. Of course, the wise saver is still concerned -- he or she doesn't want to go through the disturbance of a bank being shut down and he or she also realizes that even the FDIC itself could fail at some point in the future. The cascade of bank failures we've had over the past couple of years has already strained the institution's resources. Another downside to FDIC insurance is that banks no longer have to compensate their depositors for risk -- at the moment, a 2% rate of return can be considered decent despite all the competition in the banking industry! Additionally, banks have to pay the piper...the FDIC is funded by its member institutions rather than the taxpayer. The FDIC fees tends to leave a little less money available to pay depositors with. The FDIC will even from time to time pressure institutions to pay lower interest rates for safety's sake; this happened recently with Ally Bank. In general, savers haven't been well-served by American fiscal policy which embraces controlled inflation that erodes the value of savings. I'm sure interest rates will rise before long, but they probably will only rise when inflation also rises so the extent to which the saver benefits will be limited.

Can we benefit from FDIC protection yet still make saving worthwhile and encourage banks to compete on safety? We probably can't have everything in one system, but I think we could have two competing banking systems that could do all this in aggregate. The FDIC system could continue be the safe, no-risk system it is now. FDIC-insured institutions would tend to give low returns to depositors and tend to be less transparent to the public. Competing with these safe banks would be a new breed of bank that would offer better transparency, better interest rates, and private insurance of deposits that depositors must themselves purchase if they want it. The person who wants to play it safe would likely have the bulk of their savings in FDIC members, but he or she could also seek out those new institutions that promise safety but still perhaps offer at least marginally better interest rates. Someone who welcomes a little more risk could aim for a higher rate of interest on his or her deposits but would be able to assess how risky the bank's policies really are and also purchase private bank insurance. This increase in banking competition would probably tend to make FDIC institutions more open as well and it might just reduce the amount of money stored in those "too big to fail" institutions that were so careless with depositors' money. I think ultimately it would be good for all if it could be done.

The biggest challenge would be ensuring transparency in the new banks. As it is, you can put your money in illegal ponzi schemes and temporarily earn a high rate of interest -- these, however, are in fact even less transparent than traditional banks and will always end in failure by their very design. Clearly there would need to be some overarching organization (presumably non-governmental) that would certify and monitor the new breed of banks just as the FDIC does and may also have a role of spreading information about banks to the public similiar to what the SEC does for the stock market. Undoubtedly some "banks" will cook their books and try to bilk as many people as possible, hurting not only depositors but the private bank insurer or insurers as well...banking would no longer be so safe. The extent to which it could be made safe would depend on the vigilance of the certifying institution. If put together cautiously by the right people, however, I think this system could be a successful alternative to the FDIC system. Both systems could thrive and make each other better over time.

As it is, the FDIC and the banking system does work for the most part. I remain confident in the FDIC as an institution and fully expect the government to bail it out if it should need help so there's no reason for savers to be too alarmed at its recent financial difficulties, though we should all be concerned about the government's ability to bail out all comers. I don't have the same confidence that the banks will pay good interest rates in the future and I have even less confidence that they will embrace prudent financial practices for the long-term. We need a "private option" in banking which rewards transparency and accountability!