Since U.S. deposit insurance began in 1934, no depositor has lost a cent of insured money in a bank failure. That safety came with a price tag, and a rulebook. This week you read both.
Learning objectives. After this week you can (1) explain the safety net and how deposit insurance stops runs; (2) compute a capital requirement and show what it protects; and (3) explain the moral-hazard tradeoff.
Remember this: a safety net stops panics, and invites risk. Rules make the risk-takers pay first.
1) The safety net
Two pillars hold up modern banking: deposit insurance for the public and the lender of last resort for the system. In exchange, banks accept supervision and rules. In the U.S. the FDIC insures deposits up to $250,000 per depositor, per bank, per ownership category, paid for by premiums charged to banks. A covered depositor loses nothing by being slow, so there is no reason to run.
Example. An owner has $300,000 in one bank when it fails. $250,000 is covered; the other $50,000 is at risk.
2) The price: moral hazard
Insured depositors stop watching their bank, so the job of monitoring moves to regulators. Banks that expect rescue, especially those seen as too big to fail, can borrow cheaply and take extra risk. The rulebook pushes that risk back onto owners:
- Capital requirements: owners must fund a minimum share of assets with their own equity.
- Liquidity requirements: hold enough liquid assets to survive about 30 days of stress outflows.
- Stress tests: regulators run a severe downturn through each big bank's balance sheet.
- Risk-based premiums and resolution: riskier banks pay more for insurance, and a failed bank is wound down with shareholders losing first.
3) A capital requirement at work
Minimum Capital = Requirement × Risk-Weighted Assets
At 8% on $100M of risk-weighted assets, owners must put in at least $8M. A bad year brings $6M of loan losses: capital falls to $2M and absorbs all of it. Depositors are whole. With only $4M of capital, the same loss would reach depositors. Higher requirements make banks safer, but equity costs more than deposits, so they can mean less lending. Note: reserves are cash on hand (liquidity); capital is owners' money that absorbs losses.
4) The arena's own rulebook
Your budget can't exceed your bank: anything over it is pro-rated down. That is a strict no-leverage rule, as if every team were 100% equity. And there are no bailouts: a team that can't fund race day doesn't start. No safety net means no moral hazard, but one bad shock can end a season that credit could have bridged.
Quick self-check
(a) $300,000 in one failed bank, one ownership category: how much is at risk? (b) An 8% requirement on $100M of risk-weighted assets: minimum capital? (c) Who pays deposit insurance premiums? (Answers: $50,000; $8M; banks.)
Common mistakes
- "Deposit insurance is free stability." Its price is the monitoring it switches off.
- Mixing up capital and reserves. One absorbs losses; the other pays withdrawals.
- Judging rules in calm times. Their product is the crisis that never happens.
This week in the arena
Play examiner on your own team. Compute a liquidity-style ratio, your bank divided by this week's planned spend, and decide what minimum you would require if you wrote the rules. Then ask how your budget would change if a rule refunded half of any losing week's spend.