Deposit Insurance
What is Deposit Insurance?
Deposit insurance is a government guarantee that pays depositors up to a set limit if their bank fails, removing most of the incentive to join a run.
A public insurer collects premiums from banks and promises that if a bank fails, covered depositors are paid up to a stated ceiling. The guarantee mostly works by never being used: a depositor who knows the payout does not depend on being first in line has no reason to line up at all. The cost is moral hazard. Insured depositors stop checking whether their bank is taking risks, so the bank can fund gambles cheaply, which is why insurance always travels with capital requirements, supervision and risk-based premiums. Deposit insurance is not the same as lender-of-last-resort lending: insurance pays depositors after a bank has failed, while last-resort lending is meant to keep a solvent bank from failing at all.
Deposit Insurance: a worked example
Suppose a scheme covers the first $100,000 per depositor at each bank. Someone holding $160,000 at one bank is fully covered on $100,000 and stands in line as an ordinary creditor for the other $60,000. If the failed bank's assets ultimately cover 80 cents per dollar of uninsured claims, that depositor collects $100,000 plus 0.80 × $60,000 = $48,000, a total of $148,000 and a loss of $12,000. Splitting the same $160,000 into $80,000 at each of two banks would have put every dollar under the ceiling. This is why large uninsured balances, not small insured ones, are the money that runs.
The mistake students make with deposit insurance
Students think deposit insurance means a bank cannot fail, or that every dollar held at a bank is guaranteed. Insured banks fail regularly; what is protected is the depositor, up to the ceiling, not the institution, and balances above the ceiling take losses alongside other creditors. Insurance also covers deposit accounts only, not investment products such as mutual funds sold through the same bank.
Deposit Insurance questions
Does deposit insurance prevent banks from failing?
No, deposit insurance protects depositors rather than banks, and insured banks still fail and get closed by regulators. What it prevents is the run, because covered depositors are paid regardless of when they show up, so panic withdrawal stops being the rational response to bad news.
What is moral hazard in deposit insurance?
Moral hazard in deposit insurance is the tendency of insured banks to take more risk because their depositors no longer have a reason to monitor them. Cheap funding that is insensitive to risk makes a dangerous loan book as easy to finance as a safe one, so insurers offset it with capital rules, supervision and premiums that rise with risk.
Are all accounts at a bank covered by deposit insurance?
Only deposit accounts are covered, and only up to the legal ceiling per depositor at each insured bank. Investment products bought through a bank, such as mutual funds or securities, are not deposits and carry no such guarantee, and any balance above the ceiling is an uninsured claim on the failed bank.
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