FDIC vs. Private Sector Insurance

by: Sean Ryan

I really enjoy Megan McArdle’s blog, and generally find it uncommonly thoughtful. But yesterday she strayed into an area about which I know a little bit (very little, some might say), and I can’t let her comment pass unchallenged. Specifically, she stated:

Perhaps unlike my fellow libertarians, I do not view the government as worse than the private sector at all things. I view it as better than the private sector at some things, like producing streetlamp and policemen and armies and the FDIC and unemployment insurance.

I’m on board with armies and policemen, but the notion that the government is better at providing deposit insurance than the private sector - that the FDIC is better than a private sector provider would be - isn’t supported by anything I know about the FDIC.

The primary deficiency of the FDIC is something that seems to be endemic to government insurance schemes (which is why agencies like the PBGC are such accidents waiting to happen) - it does a very poor job of risk-rating its premia. In theory, the FDIC has several rates that reflect the riskiness of the bank whose deposits are being insured, but in practice almost everybody pays the same (minimum) rate.

A private insurer would charge premia that varied much more significantly based on the riskiness of bank balance sheets, thus providing a meaningful incentive for banks to make sure they are compensated for the risks they take on. Almost as important, premia would actually go to the intended purpose instead of (as is currently the case) serving as an off-the-government-books transfer payment system whereby premia are actually taxes used to accomplish other, only tangentially related governmental goals (such as subsidizing acquisitions of troubled banks or assets).

I suppose an obvious concern someone might raise is the case of the bond insurers, which are only barely solvent at best in part due to underestimating the risks they were insuring. I think there are two issues there.

First, a proper insurance regulator would have something to say about premia if competition started becoming irrational (just as bank regulators do at present). Second, I’m not sure bond insurers ever actually created value, as opposed to merely exploiting regulatory inefficiencies.

Their real business, after all, is essentially renting out their AAA ratings to non-AAA-rated entities. The companies always claimed to underwrite to a loss rate of zero, which was somewhat plausible when they mainly insured domestic municipal debt, but as the margins on that business compressed they sought to sustain profitability by moving increasingly into international debt and structured finance. Not an inherently awful business but one in which aspirations to a zero loss rate were never supported by a lengthy track record or, really, anything other than some analytical models. These problems don’t really attach to deposit insurance.

So if there is a great argument as to why the FDIC is a preferable way to insure deposits versus the private sector, please let me know, because I’ve never heard it.

Disclosure: No positions

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