Risk-Based Deposit Insurance: Meaning, Benefits, Limitations

Risk-based deposit insurance has premiums that reflect how careful banks are when investing their customers' savings.

The theory is that flat-rate deposit insurance shields banks from their true degree of risk-taking, promoting poor decision-making and moral hazard. Banks that use risk-based deposit insurance, on the other hand, may reconsider their risky behavior because those who take on more risk face higher insurance rates.

Understanding Risk-Based Deposit Insurance

The Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991 established risk-based deposit insurance as regular practice. During the savings and loan crisis, the number of savings and loan associations fell by 28% between 1980 and 1990, prompting regulators to change strategy and transition from a flat-rate deposit insurance system, in which premiums were set at a uniform rate across all banks, to a risk-based assessment arrangement.

The FDIC, an independent federal organization whose primary goal is to prevent a repeat of the run-on-the-bank scenarios that wreaked havoc during the Great Depression, uses deposit insurance premiums collected from banks to support the Federal Deposit Insurance Program. This program protects consumers by guaranteeing deposits of up to $250,000 at member banks in the event of a failure.

Checking, savings, certificates of deposit (CDs), and money market accounts are normally fully insured by the FDIC, as are cashier's checks and money orders issued by the failed bank. Trust accounts and Individual Retirement Accounts (IRAs) are also covered, but only to the extent that they fit the previously stated account types. 

Mutual funds, annuities, life insurance plans, stocks, bonds, and safe-deposit box contents are not insured by the FDIC.

Benefits of Risk-Based Deposit Insurance

Risk-based deposit insurance was created to discourage reckless banking and eliminate moral hazard: a scenario in which one party to an agreement engages in hazardous behavior or fails to behave in good faith because it knows the other party will face the repercussions of that action. 

Insurance firms are concerned that by providing rewards to protect against accident losses, they may inadvertently encourage risk-taking, resulting in more claims. Risk-based premiums were intended to deter such behavior by requiring banks to accept the full cost of risk.

Limitations of Risk-Based Deposit Insurance

Risk-based deposit insurance isn't always an ideal approach for reducing moral hazard. Its efficacy is dependent on the deposit insurer's capacity to adequately examine and analyze the risk characteristics of a bank's investment portfolio, which is typically a difficult undertaking.

It is realistic to presume that an outsider would struggle to fully analyze all of a bank's activities and understand the risks involved with any of its more complex products. If this is the case, the premiums charged may not accurately reflect the risk the bank is assuming, thus causing risk-based deposit insurance to fail in its aim to manage moral hazard.