Economics for One

FDIC Insurance Premiums and Moral Hazard

One of the challenges the insurance industry faces is “Moral Hazard.”

Moral hazard is a the observed phenomenon whereby, because something is insured, it becomes more likely to occur.  If a bad event (e.g. breakage or theft) will cost a certain amount, then if that event is insured, it will cost a bit less.  This makes the bad event less bad–which is the point of insurance.  Unfortunately, it also means that the insured person will not work quite as hard to prevent the bad event from happening, or, in extreme cases, may even cause the bad event to occur.

A silly illustration: if a grocery store could somehow insure every dozen eggs for $1000 against breakage, “Moral Hazard” is the insurance industry’s way of recognizing that there would somehow be a lot of broken eggs.

The industry tries to adjust for this in several ways.  One is by charging different premiums to different people depending upon their beliefs about the customer’s risk.  That’s why 16 year-old boys pay more for car insurance than 45 year-old married men.  Insurers also try to make sure there are other reasons the insured would not want the event to occur.

I had occasion to visit Lloyd’s in London a while back, and I learned that there are only two types of insurance that Lloyd’s will not place.  The first is life insurance, because the purchaser is betting someone will die–and in a world of moral hazard, Lloyd’s are uncomfortable with that idea.  The second is a pure financial guarantee.  In other words, they will not make someone financially whole simply because they lost money.  They must instead insure the events that might cause them to lose the money (fire, theft, etc.).  Over hundreds of years as the world’s foremost insurance marketplace, Lloyd’s has found the moral hazard associated with pure financial guarantees to be too great.  That’s because if all that is at stake is money, and the insurance will make one financially whole, then there is no alternative reason to prevent the loss event.

Which brings us to the FDIC.

The Federal Deposit Insurance Corporation insures depositors who put money in a US bank against loss, up to a certain limit.  Another way of saying this is that they insure the banks against loss, so that the banks will be able to repay their creditors (the depositors) in the event that the bank loses money.

This is a financial guarantee.  They are not insuring against an underlying event; they are making a pure financial guarantee–the type you could not buy at Lloyd’s in London.

But it gets worse.

The FDIC charges the same premium to all participating banks regardless of their perceived risks.  Of course, the “risks” involved are basically the risks associated with the bank’s loans.  So the bank is free to make any loans it likes, and it will not see a change in premiums.

The result is that all banks face the exact same downside potential, regardless of their business decisions.

Since banking is a somewhat competitive market, banks will try to get a higher return by charging more for the loans they make.  This force moves them toward making bigger and riskier loans, where they can charge higher fees and interest.

Under ordinary market forces, this would also increase their downside potential, which would be a force reducing the risks banks take in their loan decisions.  However, with FDIC insurance, we’ve eliminated this force, leaving only the force toward making riskier loans.

The result is that banks compete against each other by making riskier and riskier loans.  They may not realize they are doing this, but that is the market they are in.

The result is a steady increase in the risk levels of bank loan portfolios.  And that can only lead to one conclusion: a collapse in the loan portfolios of many banks.  Specifically, it leads to a collapse in the portfolios of the most competitive banks.  In order to be competitive they took on the risky loans.  And because they are successfully competitive, they are also the largest banks.

Does any of this sound familiar?

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1 Comment so far

  1. Nellie April 26th, 2009 8:32 am

    Good post.

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