Federal Deposit Insurance Acts

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Federal Deposit Insurance Acts

Steven Ramirez

When President Franklin D. Roosevelt took office in 1933 the banking industry was on the verge of collapse. Governors of thirty-four states ordered banks to close their doors to stem the tide of the massive withdrawals, causing millions of panic-stricken Americans to withdraw their funds from the national banking system. This led five thousand banks to fail between 1929 and 1933.

In 1933 Congress acted to restore depositor confidence in the banking system by adopting a law that would insure bank deposits even in the face of a failing bank system. Legislators hoped deposit insurance would encourage the flow of money back into the nation's banking system. At the time, Congress understood that when a bank failed, depositors lost the value of their deposits, causing panic and destabilizing the economy. Accordingly, Congress adopted the Banking Act of 1933 and created the Federal Deposit Insurance Corporation (FDIC) to administer a deposit insurance program. The law required the banking industry to fund deposit insurance which in turn assured depositors they would get their money back even if their bank failed.

As an independent federal agency, the FDIC is governed by a three member board that includes the Comptroller of the Currency. The FDIC has a number of responsibilities, including regulating banks to assure they do not expose the insurance fund to undue risks, and administering failed banks. The FDIC acts as a bankruptcy court for insured depository institutions and in this capacity it frequently brings civil suits against those whose misconduct caused the bank to fail.

The act has successfully achieved two economic benefits. Because the full faith and credit of the United States backs deposit insurance, banks enjoy a lower cost of capital than they would otherwise pay. This cost-cutting enables the bank to lend out funds at a lower cost to borrowers and entrepreneurs. The act has also successfully warded off bank failures.

Many economists have widely regarded deposit insurance as a brilliant solution to a significant and exceedingly difficult problem. Economist John Kenneth Galbraith may have put it best by stating that deposit insurance remedied a "grievous defect" in laissez-faire economics (the belief that free markets alone can best secure economic prosperity) and that "rarely has so much been accomplished by a single law."

The act, however, was not without critics. One of the most vehement opponents of deposit insurance was the American Bankers Association. Yet in the decade following the adoption of the law, total bank failures decreased dramatically and so the major opponents of the legislation also seemed to be its primary beneficiaries. Nevertheless, market enthusiasts continue to believe depositors themselves can exert discipline over banks that take too many risks—and that deposit insurance is not needed to prevent bank failures. Under this approach, depositors will punish weak banks and create market disincentives for poor management. These laissez faire enthusiasts fail to explain why market discipline did not prevent the onslaught of bank failures in the 1930s, nor do these commentators fully admit that the line between market discipline and a bank panic is thin indeed. By the time depositors realize a bank is in precarious condition, the bank is just as likely to fail as reform its management practices.

CIRCUMSTANCES LEADING TO THE ADOPTION OF THE ACT

The Banking Act of 1933 was a key component of President Franklin D. Roosevelt's New Deal, the first major attempt to regulate the economy and to resolve the Great Depression. The Depression was an unprecedented economic calamity that ultimately gave rise to an unemployment rate of 25 percent and to a 33 percent contraction of the nation's economy. In the election of 1932, Franklin D. Roosevelt promised to deliver economic reform, and the New Deal was an effort to adhere to that promise. Banking regulation was a natural starting point for the New Deal, and the Banking Act of 1933 was enacted as part of the historic first Hundred Days of the Roosevelt administration. The Banking Act of 1933 included many measures designed to stem the devastation in the banking industry, and deposit insurance was one of the keys to resolving the banking crisis.

The U.S. Supreme Court has interpreted the 1933 Banking Act on a number of occasions. For example, in FDIC v. Philadelphia Gear Corporation Act (1986), the Supreme Court held that the term "deposit" under the act included a standby letter of credit backed by a promissory note (a promise to pay a debt). This case suggested that deposit insurance extended to much more than a traditional savings or checking account, with the Court giving the act surprising depth when deciding this case. A decade later, however, the Court decided a case that limited the scope of the act. In Atherton v. FDIC (1997), the Supreme Court held that there was not sufficient federal interest warranting the creation of any common law duty of care (the obligation of directors to pay for the costs of their negligence) for directors of insured banks. This meant that states are generally free to insulate directors from liability for negligent bank management and are basically able to impose the costs of sloppy banking on the U.S. taxpayers instead.

SUBSEQUENT LEGISLATION

The federal deposit insurance program has evolved over the decades. In 1934, under the National Housing Act, Congress created the Federal Savings and Loan Insurance Corporation to insure the deposits held in the nation's savings and loans. Under the Federal Deposit Insurance Act of 1950, Congress extended deposit insurance to state banks, created under state laws. In the 1970s Congress extended deposit insurance to credit unions in the Federal Credit Union Act, and during the 1980s the regulation of banking, in accordance with the deregulatory dogma of the time, was dramatically loosened, leading to a new set of bank failures. Congress responded with the Financial Institutions Reform Recovery and Enforcement Act. This act served to broadly strengthen the hand of bank regulators and to recapitalize the depleted insurance funds. Since this act, the FDIC has administered both the Bank Insurance Fund for banks and the Savings Association Insurance Fund for savings and loans. In 1991 the Federal Deposit Insurance Corporation Improvement Act instituted a regime of risk-based assessments upon insured banks, requiring weaker banks to pay more for deposit insurance than financially strong banks.

Prior to deposit insurance, bank runs were embedded in our culture. For example, in the classic film It's a Wonderful Life, a central scene is a run on the Bailey Brothers Building and Loan, operated by George Bailey (played by James Stewart). To today's audience the concept of running down to the bank to get your cash back before they run out is an altogether foreign idea. Bank runs no longer exist; even when banks are known to be in adverse financial straits, depositors no longer rush to the bank to withdraw deposits. Depositors are now secure enough that even if a bank becomes financially insolvent, they know the U.S. government stands behind virtually every bank in the land. But in the 1930s fear could grip a community at the slightest whiff of financial trouble—having a very real and corrosive effect on the economy. For this reason, the Banking Act of 1933 was signed into law:

The purpose of this legislation is to protect the people of the United States in the right to have banks in which their deposits will be safe. They have a right to expect of Congress the establishment and maintenance of a system of banks in the United States where citizens may place their hard earnings with reasonable expectation of being able to get them out again upon demand... [T]he purpose of the bill is to ensure that the community is saved from the shock of a bank failure, and every citizen [is] given an opportunity to withdraw his deposits.

See also: Glass-Steagall Act; National Housing Act