The FDIC

Question - Is the FDIC a good thing? Does its existence cause banks to take unnecessary risks since they know there is a parachute that can be used when they overextend?

Response - In all honesty, whether or not a particular policy passed into law or a particular bureaucratic entity created by the legislature is 'good' depends entirely upon one's personal preferences, agenda and ideology. However, permit me to take a leap of faith and assume that by 'good' you really mean 'efficient.'

Is the FDIC an efficient thing?

It depends.

Is it more efficient than having nothing of the sort in place while simultaneously keeping all the other characteristics of the national banking system intact? Yes.

Is it more efficient than having nothing of the sort in place while simultaneously culling the waste out of the current mess of banking regulations resulting in a free market for banking? No.

The FDIC (Federal Deposit Insurance Corporation) serves as a firewall for the national banking system. Since it guarantees a depositor's account up to $250,000, the incentive for account-holders to initiate a 'run' on the bank in times of economic contraction is severely muted (if not eliminated altogether).

The FDIC was created by legislation signed into law by Franklin Roosevelt in 1933 in response to the massive number of bank collapses during the initial years of the Great Depression. These bank closings created enormous deflationary pressures on the national economy due to the resulting evaporation of available credit. Since banks hold only a fraction of their deposits on hand as reserves to cover withdrawals, the remainder is available to loan out at interest. This, in effect, adds to the available money supply since the depositors are writing checks upon their accounts at the same time their cash is being loaned out. As a result of this fact (called fractional reserve banking), whenever a bank failed, not only did its account-holders lose their funds, but the credit that the bank had extended (effectively adding to the nation's money supply) disappeared. From 1929 to 1933, the money supply in the United States declined by 1/3. The FDIC was an effort by the Federal Government to limit any future threat of similar deflationary pressures in the banking sector.

You may be surprised to discover that not a single bank failed in Canada throughout the Great Depression (and Canada offered absolutely no government deposit insurance). Canada certainly suffered (as the entire world suffered) from the Great Depression, but not the way the United States did. The explanation is rather interesting as well as simple to understand.

Canada's banks had thousands of branches spread throughout the country. So, if the agricultural sector was hit hard, liquid assets from industrial and commercial sector-concentrated branches could be shifted to agricultural sector-concentrated branches and any threat was thus mitigated.

The United States possessed many local and state regulations controlling the number of branches big out-of-town or out-of-state banks could open within certain regions. The goal was to protect smaller community banks from the 'big boys.' The result was the unfortunate (and unintended) consequence of having more banks (than would have otherwise) having all of their eggs in just one basket. So, when a community suffered, the banks felt the pinch and had few opportunities for relief.

If these kinds of regulations were eliminated and the United States banking system were to grow in a similar fashion to the Canadian banking system, then the FDIC would be unnecessary because the banks would be able to take care of themselves in similar times of overall economic distress.

Now, on to the second portion of your question. Does the existence of the FDIC permit banks to take risks they otherwise wouldn't take because they don't have to worry about their depositors losing their money?

No, because whether or not a bank stays in business has to do entirely with its profitability. The bank (as any business) cares about its bottom-line first. If a bank is profitable, then naturally its account-holders will not have anything to worry about anyway.

The only way a bank can be consistently profitable (in a free market, absent government largesse) is if its decisions regarding loan extensions and investments are productive, efficient decisions. Risks must be effectively hedged and managed. Losses will be suffered for inefficient investments and profits will be gained when investments turn out to have been sound. As a result, the 'best' banks will earn the most money, be the most solvent, and attract the most account-holders.

Does this adequately answer your questions? If not, feel free to ask as many follow-up questions as you feel you need to.