ABC's of Banking

Provided by the State of Connecticut, Department of Banking, based on information from the Conference of State Bank Supervisors (CSBS) 

Deposit Insurance

The Federal Deposit Insurance Corporation (FDIC) is an independent federal government agency which insures deposits in commercial banks and thrifts. 

Federal deposit insurance is mandatory for all federally-chartered banks and savings institutions. All states also require federal deposit insurance for newly-chartered banks that accept retail deposits. (Connecticut law, however, allows the organization of an uninsured bank that does not accept retail deposits).

The FDIC has no authority to charter a bank, and may only close a bank if the bank's charterer fails to act in an emergency. The FDIC depends on the charterer to declare a bank in danger of failure before it can step in. It does, however, have the authority to revoke an institution's deposit insurance, essentially forcing the bank to be closed. It also has direct supervisory authority over state-chartered banks that are not members of the Federal Reserve System, and backup authority over national and Fed-member banks.

The FDIC has a five-member board that includes the Chairman of the FDIC, the Comptroller of the Currency, the Director of the Office of Thrift Supervision, and two public members appointed by the President and confirmed by the Senate. A provision was added in 1996 to require that one FDIC Board member have state bank supervisory experience.

How Deposit Insurance Works

The FDIC manages two deposit insurance funds, the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF).

The BIF insures deposits in commercial banks and savings banks up to a maximum of $100,000 per account. BIF receives no taxpayer money. Insured banks pay for deposit insurance through premium assessments on their domestic deposits. Foreign deposits -- deposits at branch offices of domestic banks outside the United States or its overseas territories -- are not insured, and are thus not subject to deposit insurance premiums.

From 1934 to 1989, the deposit insurance premium for banks was 12 cents per $100 (12 basis points) of domestic deposits. The 1989 Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) authorized the FDIC to raise premiums if necessary to bolster the deposit insurance fund. The 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) increased that authority by authorizing the FDIC to levy special and emergency assessments in addition to the usual premiums.

FDICIA required the FDIC to maintain assessments at an average of 23 basis points until the Bank Insurance Fund reached a level of 1.25% of insured deposits, a level the fund reached in 1995. FDICIA also directed the FDIC to develop a system of risk-based deposit insurance premiums.

In 1996, Congress made several changes to the deposit insurance system. At that time, while the BIF was at its required level, the SAIF had not yet reached the required reserve ratio of 1.25%, resulting in a premium disparity. The Economic Growth and Regulatory Relief Act of 1996 capitalized SAIF through a one-time assessment on SAIF deposits. The legislation also called for a merger of the BIF and SAIF, but only provided that the thrift charter had been eliminated. If, as seems likely, the thrift charter remains a chartering option, the question of a premium disparity could arise again in the future.

When an insured bank fails, the FDIC receives the institution from its charterer and makes sure that insured depositors have access to their accounts. The FDIC may conduct this resolution process in several ways:

  • The FDIC can liquidate an institution, meaning that it issues checks for all insured deposits, dissolves the bank and sells off the bank's assets to recoup its losses. Uninsured depositors almost always lose money in a liquidation, depending on how much the FDIC is able to recover by selling assets. Liquidation generally requires a larger cash outlay than other resolution methods.
  • The FDIC can execute an insured deposit transfer, in which it sells the failed bank's insured deposits to another institution for a fee. This is similar to a liquidation, in that the FDIC makes no effort to preserve the failed bank as an institution; the agency sells off its assets and pays the uninsured depositors according to what it recovers.
  • The FDIC can negotiate a purchase and assumption (P&A) transaction, in which a healthy institution buys all or most of a failed bank's assets as well as its deposits. The FDIC restores the assets of the failed institution with cash payments or guarantees, so the acquiring bank takes on little risk. Traditionally, purchase and assumption transactions have protected uninsured as well as insured deposits. FDICIA, however, prohibited the FDIC from redeeming uninsured deposits after 1994 unless the President, the Secretary of the Treasury and the FDIC jointly determine that failure to pay off uninsured deposits would pose an unacceptable risk to the economy.
  • The FDIC can offer open bank assistance (OBA), or an assisted transaction, in which it arranges for the purchase or recapitalization of an institution before it actually fails. Uninsured depositors are usually protected in these transactions.

The concept of deposit insurance originated in the states many years before it became a policy of the federal government. New York created the first insurance program in 1829, and a total of 14 states established deposit insurance systems before 1933. State insurance funds were successful until the passage of the National Bank Act of 1863. After the National Bank Act, so many state banks converted to national charters to avoid the national tax on state bank notes that state deposit insurance funds did not have a broad enough base to be effective. Later, agricultural crises of the late 1920s contributed to the ultimate collapse of state insurance funds, since these funds could not diversify their risk. The major difference between these funds and today's federal insurance fund was that banks had been directly involved in the supervision and capitalization of their state insurance funds.

The National Banking Act of 1863, while not directly addressing the issue of deposit insurance, sought to stabilize the banking system by unifying the currency and decreasing the possibility of bank failures.

The Federal Reserve Act of 1913 was created to prevent bank runs by injecting liquidity into the financial markets when necessary to help maintain depositor confidence. In 1932, however, after an alarming number of bank failures, the public began withdrawing their deposits. This led to more bank closings and more runs, a spiral of panic that ended with the Bank Holiday of 1933.

The National Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC), under the Federal Deposit Insurance Act, to provide insurance for all banks. FDIC member banks were originally required to join the Federal Reserve System as well. The Act also gave the FDIC regulatory and examination functions. Banks who participated in the insurance plan were assessed an annual fee of one-half of one percent (50 basis points) of deposits. If these fees were inadequate, the FDIC had the power to impose further assessments. Deposit insurance coverage at the time was $2,500.

The Federal Deposit Insurance Act of 1950 required the FDIC to rebate 60% of bank assessments after deducting operating costs and insurance losses. This law was enacted because the FDIC's net worth in 1946 was $1 billion, a figure believed to be sufficient to cover almost any banking problem. Banks had become stronger and felt that the assessment rate was too high.

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) transferred the savings and loan insurance fund, FSLIC, to the FDIC; it renamed the Bank Insurance Fund and created the Savings Association Insurance Fund. FIRREA required that the FDIC maintain the Bank Insurance Fund at 1.25% of insured deposits. To achieve this level, it gave the FDIC the authority to raise premiums as needed, to a maximum level of 35 cents per $100. (This ceiling was removed in 1990.)

The Federal Deposit Insurance Corporation Improvement Act of 1991 significantly expanded the FDIC's authority over all insured institutions. It directed the FDIC to develop a system of risk-based deposit insurance premiums, which the agency enacted in 1992, and continues to modify. It also established a system of mandatory regulatory sanctions against banks with declining capital, in an effort to minimize losses to the Bank Insurance Fund.

The Economic Growth and Regulatory Relief Act of 1996 capitalized SAIF through a one-time assessment on SAIF deposits (approximately 65 basis points). The legislation also called for a merger of the BIF and SAIF, but only provided that the thrift charter had been eliminated.

Why Do We Need Deposit Insurance?

Deposit insurance provides three important benefits to the economy:

  1. It assures small depositors that their deposits are safe, and that their deposits will be immediately available to them if their bank fails.
  2. It maintains public confidence in the banking system, thus fostering economic stability. Without the confidence of the public, banks could not lend money, but would have to keep depositors' money on hand in cash at all times.
  3. It supports the banking structure. Deposit insurance makes it possible for the United States to have a system of both large and small banks; if there were no deposit insurance, the banking industry would probably be concentrated in the hands of a very few enormous banks.

An argument against deposit insurance is that it reduces "depositor discipline," which is the depositors' means of policing bank activity. This is true. If depositor discipline alone governed the banking system, however, we would see a significant increase in bank runs, losses to small savers and economic instability, particularly in credit markets. The difficulty in maintaining a successful deposit insurance system lies in maintaining a role for depositor discipline without threatening the overall stability of the banking system.

Visit the FDIC for more information on deposit insurance.

Lesson Five: Bank Geographic Structure