What “Deposit Insurance” Really Means

Lately, you’ve heard much about the term “deposit insurance.” As in, how U.S. bank accounts are insured to $250,000 by the Federal Deposit Insurance Corp. (FDIC).

Most of the discussion has been in the context of the failed Silicon Valley Bank (SVB) of Santa Clara, California, the second largest bank failure in U.S. history.

Let’s discuss bank failures for a moment. Then, I’ll tell you about an entirely different way to look at deposit insurance; meaning a form of deposit insurance that’s solid as a rock.

Indeed, this other kind of deposit insurance goes way beyond the political whims of federal bureaucrats and monetary policymakers. But let’s not get too far ahead. First, here’s some quick background.

The idea of traditional deposit insurance is that your bank accounts are… well… “insured.”

It goes back to the Great Depression of the 1930s, when thousands of U.S. banks failed. That is, a bank would encounter a “run,” in which large numbers of people wanted their money back all at once.

Unless the bank was flush with cash (which was almost never), it could not pay everyone back; not all at once, anyhow, and definitely not in a panic scenario. So, lacking sufficient funds, the bank would close its doors and, in essence, go out of business. The depositors’ money was gone.

Poof. Nothing.

In the early days of the Depression, large numbers of bank failures were a nationwide financial calamity. Entire groups of people — even entire regions — were left broke and impoverished. So in 1934 Congress established the Federal Deposit Insurance Corporation (FDIC), to backstop deposits to a certain amount.

Under the original 1934 law, FDIC covered $5,000 per account, which was not bad for those days but by no means overly generous. By 1980, the limit had moved up to $100,000. And today it’s $250,000.

The idea has long been to protect large numbers of small and modest-scale depositors up to some level, more or less appropriate to the economic tenor of the era, whether the Great Depression, or 1980s, or currently. If a bank fails, depositors will have access to funds up to the insured limit, with almost no questions asked.

With that background, you’ve likely followed the news of how SVB failed. Headquartered in the heart of the South Bay Area, it has branches as far away as New York, Wellesley, Massachusetts and even a subsidiary in Great Britain.

I’ll skip the gory details of why and how SVB failed. Suffice to know that management was a petting zoo of incompetent boneheads, emblematic of our era. They totally failed at Risk Management 101, and their business cratered.

In the immediate hours after SVB went under, word quickly spread that depositors were limited to “only” $250,000 under FDIC guidelines. Whoa!

Suddenly, an entirely new element of the story cracked open, namely that over 97% of SVB deposits exceeded that $250,000 limit. Huh? Wait a sec…

Think about that… Who has over $250,000 in the bank? Well yes, wealthy people. And one heck of a lot of them banked at SVB, which catered to customers seeking “wealth management” services.

Now step back and think about your own life, or about people you know; people with whom you went to school, or with whom you work or associate. Who has over $250,000 sitting in a bank account?

The Daily Reckoning