Federal Deposit Insurance Corporation (FDIC) - Business in United States of America
Identification: Federal agency that increases public confidence in the financial system by insuring deposits in banks and savings and loans up to a specified dollar amount per depositor
Date: Established in 1933
Significance: Establishment of the Federal Deposit Insurance Corporation helped eliminate bank panics, which had been a major contributor to business depressions. There has been no repetition of the deluge of bank failures that occurred in 1929-1933. Although federal deposit insurance did not formally begin until 1933, there had been numerous earlier attempts to achieve the same results. Since early in the nineteenth century, banknotes and bank deposits were an important part of the nation’s supply of money. These bank liabilities cost very little to create and could be used to acquire valuable assets, so there was a chronic tendency for banks to create more notes and deposits than they could redeem in cash.
Periodic bank panics became a characteristic of the nineteenth century economy. Consequently, state governments experimented with the equivalent of deposit insurance. A notable example was the Safety Fund system established by New York State in 1827. This provided insurance for banknotes and bank deposits, financed by an assessment on bank capital and supported by bank examination to monitor the quality of bank loans. However, a wave of bank failures broke the system in 1842. Other states protected depositors by imposing the requirement that banks keep cash reserves equal to a percentage of their deposit liabilities.
Federal government protection for holders of banknotes was established by U.S. Civil War legislation. The National Banking Acts of 1863 and 1864 created a system of national banks whose banknote issues were protected by the deposit of government securities. A tax on non-national banknotes in 1865 drove those out of existence. National banks were also subject to substantial required cash reserves. However, bank panics persisted. During panics in 1873, 1893, and 1907, many banks resorted to “suspension of specie payments”—that is, they temporarily refused to pay out cash to depositors, while continuing the rest of their normal banking operations.
These suspensions focused attention on the “inelasticity” of currency supply—there was no way to increase the amount of currency in times when depositors wanted more cash. The desire to create an “elastic currency” was embodied in the Federal Reserve Act of 1913. Proposals for federal insurance of bank deposits were advanced as early as 1886, and federal insurance was advocated by William Jennings Bryan in his unsuccessful presidential campaign in 1908. Creation of the Federal Reserve system improved depositor protection by strengthening reserve requirements and bank examination, and by permitting the Federal Reserve to lend to banks and create additional currency in a crisis.
Individual states started experimenting with deposit insurance, beginning with Oklahoma in 1907. By 1918, eight states had such programs. An important motive was to preserve the large number of small unit banks by maintaining restrictions on branch banking. Extending branch banking was frequently proposed as a way to reduce bank risks and failures. The farm depression of the 1920’s led to a large increase in the number of bank failures, and the state deposit-protection programs were unable to handle the claims against them. So all had shut down by 1929. However, most of the bank failures of the 1920’s involved small banks in small towns. In most of the country, bank deposits became more widely used. The number of checking accounts increased from11 million in 1909 to more than 23 million in 1920.
As the economy slid into the Great Depression after 1929, an avalanche of bank failures occurred. Large-bank failures in 1930 involved banks that had taken unduly risky positions speculating in stocks or real estate. As bank failures escalated, depositors withdrew cash, putting pressure on the banks to contract their loans and to hold larger cash reserves. These tendencies, along with actual losses of deposit funds, worsened the economic downswing.
New Deal Actions
In the final months of 1932, a number of states imposed “bank holidays,” suspending cash payout in an effort to protect banks from the heavy currency withdrawal. On his inauguration in March, 1933, President Franklin D. Roosevelt extended the bank holiday to the entire country. Every bank was required to undergo examination of its assets and would be allowed to reopen only when found to be solvent. In 1933, 4,000 banks closed permanently, involving $3.6 billion of deposits and inflicting a half-billion of losses on depositors. Most banks were reopened within a few days. The shock therapy was effective. Panic ended, and currency flowed back into the banks. However, the banking system had experienced a severe shakeout. From a high of around 30,000 in 1920, the number of banks had declined to half that number.
Congress quickly moved to try to reform the structure of the banking system. The Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC), with capital provided by the Treasury, the Federal Reserve, and the banks. All member banks of the Federal Reserve system were required to have their deposits insured, and other banks could join the system if approved (and most of them did). Coverage began January 1, 1934. Initially, coverage was limited to $2,500 for each depositor; it was increased to $5,000 in mid-1934 and to $10,000 in 1950. Each bank was required to pay a premium based on deposits. The initial level of 0.5 percent of deposits proved far higher than necessary. From 1934, the premium was 0.085 percent. After 1950, premiums became flexible based on experience.
Within the first year, 1934, insurance covered 97 percent of commercial-bank deposits, and the proportion moved still higher. The Federal Deposit Insurance Corporation was authorized (in cooperation with other banking agencies) to examine insured banks, and this power helped sustain bank solvency. The agency soon developed two ways of dealing with failing banks. One was simply to pay off covered deposits without delay and try to cash in the bank’s assets. Deposits exceeding the coverage limit might suffer some loss. The second approach was to merge the failing bank into another solvent institution. The latter arrangement would protect all depositors from loss.
The Federal Deposit Insurance Corporation began operation under favorable conditions. Bad banks had been purged from the system, and surviving bankers were strongly risk averse. In the first decade of Federal Deposit Insurance Corporation operation, an average of forty-nine banks failed each year. Between 1944 and 1960, there were fewer than ten failures each year, with negligible depositor losses. Never again would the financial system experience the kind of deflationary tidal wave experienced in 1929-1933.
In 1980, deposit insurance coverage was extended to $100,000 in the Depository Institutions Deregulation and Monetary Control Act. Deregulation permitted banks to take greater risks in the hope of higher profits. As a result, the number of bank failures increased sharply during the 1980’s. In 1984, Continental Illinois, one of the nation’s ten largest banks, became insolvent. The Federal Deposit Insurance Corporation was able to arrange a merger on terms that averted depositor loss. This kind of bailout of large depositors came under criticism as weakening their motivation to monitor the banks’ risky activities. Banks’ experience had parallels with the savings and loan crisis. The number of failures confronting the Federal Deposit Insurance Corporation exceeded two hundred a year in 1987-1989, then dropped rapidly. In 1991, Congress adopted the Federal Deposit Insurance Corporation Improvement Act. This increased insurance premiums and restricted the Federal Deposit Insurance Corporation’s latitude in large-bank settlements. The FDIC was given more restrictive guidelines for monitoring bank capital. As a result, bank failures after 1995 returned to negligible levels, ranging from two to twelve per year from2000-2007.
Financial Crisis of 2008
The financial crisis of 2007-2008 raised bank failures to the highest level since 1994. The failures generally stemmed from bank involvement in subprime mortgage lending. The Federal Deposit Insurance Corporation was involved in each case, trying to arrange mergers that would protect all depositors. They were able to do this for Wachovia, which was absorbed by Wells Fargo in October, 2008. However, IndyMac, which failed in July, 2008, had roughly $1 billion in uninsured deposits held by 10,000 depositors. Washington Mutual (“WaMu”) failed in late September, 2008. With more than $300 billion of reported assets, it was the largest bank failure in U.S. history. WaMu was merged into JPMorgan Chase on terms that wiped out WaMu stockholders and some of their nondeposit creditors.
The financial rescue package adopted by Congress on October 3, 2008, the Emergency Economic Stabilization Act, increased federal deposit insurance coverage from $100,000 to $250,000. A few days earlier the government had created temporary insurance for existing accounts with money-market mutual funds, but this was not put under FDIC.
Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963. Pays extensive attention to banking evolution and particularly the developments of the 1920’s and 1930’s.
Golembe, Carter. “The Deposit Insurance Legislation of 1933: An Examination of Its Antecedents and Purposes.” Political Science Quarterly 75, no. 2 (1960): 181-200. Good detail on pre-1933 developments; stresses that deposit insurance was long seen as a way of preserving the country’s system of small, independent banks.
Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 7th ed. New York: Pearson/ Addison Wesley, 2004. This college textbook thoroughly covers recent developments in bank supervision and deposit insurance.
Redburn, F. Stevens. “Never Lost a Penny: An Assessment of Federal Deposit Insurance.” Journal of Policy Analysis and Management 7, no. 4 (1988): 687-702. Very critical of the existing deposit insurance arrangements, which the author claims “threaten to destabilize the U.S. banking system.”
Seidman, L. William. Full Faith and Credit. New York: Random House, 1993. Seidman served as FDIC chair from1985 to 1991. This is a colorful and entertaining memoir of a turbulent period.
Sprague, Irvine H. Bailout: An Insider’s Account of Bank Failures and Rescues. Washington, D.C.: Beard Books, 2000. A former chair and director of the FDIC (1972-1985) describes a number of bank bailouts and failures, beginning with Commonwealth in 1972.
Trescott, Paul B. Financing American Enterprise: The Story of Commercial Banking. New York: Harper & Row, 1963. A nontechnical narrative that identifies the major steps in depositor protection from the 1820’s.
See also: Deregulation of financial institutions; Farm Credit Administration; financial crisis of 2008; New Deal programs; Panic of 1907; savings and loan associations.