Question

Briefly explain what FDIC is and the function it performs for the banking system. Then explain how it creates a moral hazard. Now suppose a world without deposit insurance, what are some of the mechanisms that would arise to “punish” bank managers who acted irresponsibly? Now think about how the likelihood of a major economic depression would change if federal deposit insurance were eliminated. Explain.

Answer 1

FDIC

The Federal Deposit Insurance Corporation (FDIC) is a United States government corporation which provides deposit insurance to depositors in US commercial banks and saving institutions. It was created by the Banking Act in 1933 after the stock market crash of 1929. It was enacted during the great depression to restore trust in the American banking system. It finds alternative ways to insure deposit holders against potential bank insolvency.

A moral hazard is a situation where the probability that a person can cause or create or inflate a loss intentionally increases. FDIC insurance provides a potential payout in the event a bank failure. Since FDIC insures the depositors into the bank and the depositors can claim as much as they have in their account so, the moral hazard it can cause is that to shape or form with someone who robs the same bank they do business with. This is so because they can steal the money and still withdraw the full amount of their funds with the bank.

Deposit insurance should never be available on demand unless it is being purchased by depositors. Premiums should be risk rated. It should not be unlimited because effective ceilings also reduce moral hazards.