Does the FDIC Make Banks Riskier?

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During the Great Depression many banks failed, and many depositors lost everything they had. As a result of the banking crisis, in the early 1930s, the government created a new institution in order to make banks safer. This institution is the Federal Deposit Insurance Corporation (FDIC).

The FDIC is charged with insuring bank deposits up to a certain amount. Banks have to register with the FDIC and pay insurance premiums, and if these banks fail, then those who have deposits with these banks are safe. What happens is that when a bank fails, either the FDIC tries to make a fire sale of the failing bank to a solvent one or the FDIC runs the bank itself while winding down its operations as depositors collect their money.

This sounds like a great system. After all, now you can put your money in the bank and feel safe.

Unfortunately, things are more complicated than this, and the fact of the matter is that the FDIC has made the banking system riskier and more vulnerable to a crisis than it was before the Great Depression. Here’s why.

Without FDIC insurance, you, as a depositor in a bank, are going to look very carefully at the kinds of activities your bank is engaged in. You want to make sure that the bank isn’t leveraging up its balance sheet too much and that it is making responsible loans. Of course, banks that operate the most prudent and conservative operations are going to earn the lowest rate of return on their investments.

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