Why raising the FDIC insurance limit would hurt most bank customers

You might expect that more insurance would make things safer. However, that’s not necessarily true when it comes to proposals to raise the Federal Deposit Insurance Corp. (FDIC) insurance limit.

Bank finances can work differently from what many consumers expect. For banks, loans are considered assets because they generate income, while customer deposits are considered liabilities because banks must eventually repay them.

In keeping with this counterintuitive view, a bipartisan U.S. Senate bill, the Main Street Depositor Protection Act, would benefit fewer than 1% of the largest accounts rather than mainstream depositors. And critics say that raising the FDIC deposit insurance limit from $250,000 to $10 million could actually make banking riskier rather than safer.

For the average banking customer, the key issue is how to protect their deposits, whether or not this bill passes.

Why is there FDIC deposit insurance?

A good place to start when thinking about this issue is to remember why deposit insurance exists in the first place.

When you deposit money in a bank, it doesn’t just sit in a vault gathering dust. For the bank to pay you interest on your deposits and fund its operations, it needs to make money by investing it or lending some of it to borrowers.

The bank keeps some cash on hand to process transactions, including customer withdrawals. Typically, though, only a small percentage of deposits are needed on any given day. The bank only needs to keep enough money on hand to cover those needs.

The problem is that if a large number of depositors need their money all at once, the bank may not have enough cash on hand to cover it. This is especially true if some of the bank’s investments have gone sour, or if borrowers have defaulted on their loans.

When depositors sense there’s a risk that they may not be able to get their money back, many panic and rush to withdraw their deposits while they still can. That just makes the bank’s cash flow problem even worse.

This type of panic is known as a bank run. Bank runs caused widespread bank failures that helped trigger the Great Depression in the 1930s. To make people less likely to panic and want to take their money from banks all at once, the U.S. government created FDIC insurance.

FDIC insurance is funded by fees charged to banks. The money collected is used to pay depositors back if their bank fails. With this protection in place, bank runs have become a lot less common. As a result, the banking system has been more stable overall.

What is the FDIC insurance limit, and how does it work today?

While the FDIC insurance fund is available to cover deposits lost in bank failures, it doesn’t have unlimited funds. So, the FDIC puts limits on how much it will cover.

Current FDIC insurance coverage basics

The current FDIC insurance limit is $250,000 per depositor, per bank, per ownership category, at any FDIC-member institution. Joint accounts are covered up to $500,000. Trust accounts are covered up to $250,000 per beneficiary, with a maximum of five beneficiaries. In each case, this works out to $250,000 per depositor.

Only deposit accounts such as CDs, savings, money market, and checking are covered. If, for example, a bank offers investment products, those are not covered.

Also, you only get $250,000 of protection at each institution. So, for example, if you have $400,000 in a savings account, you can’t get it all covered by splitting it into two accounts at the same bank.

Who benefits from current protections?

The $250,000 FDIC insured amount is easily enough to cover most bank accounts. According to the Federal Reserve’s Summary of Consumer Finances, the median amount of money Americans have in bank accounts is $34,000. Figures from the Federal Financial Institutions Examination Council show that just over 99% of bank accounts are below the $250,000 FDIC insurance limit.

Congressional proposals to raise the FDIC insurance limit

Since the current limit does such a comprehensive job of covering deposit accounts, why raise it?

Economic conditions change over time. FDIC insurance started back in 1933. A dollar back then would be worth less than a nickel today. So, it’s been necessary to occasionally adjust the amount of FDIC insurance per account.

The initial FDIC insurance limit was $2,500 — just 1% of today’s limit. This has been raised seven times, to reach today’s $250,000 limit. The most recent increase was made to calm depositors during the 2008 banking crisis.

What lawmakers are proposing

The proposed Main Street Depositor Protection Act would raise the amount of FDIC insurance per account to $10 million. That’s 40 times the current limit. In both dollar and percentage terms, this would be the biggest single increase ever — by far.

The increase would apply only to noninterest-bearing transaction accounts — essentially, checking accounts. While banks would have to pony up larger fees to fund this new insurance coverage, the bill seeks to ease the shock of that new cost by allowing community banks with under $10 billion in assets to delay paying it for ten years.

Political appeal vs. economic reality

A bill with “Main Street” in the title might sound like it would help the average bank customer. However, fewer than 1% of bank accounts are over the current limit of $250,000. Plus, since it only applies to checking accounts, it would actually help only a portion of that 1%.

So, the increase in the deposit limit would benefit very wealthy individuals and medium-to-large business accounts. However, there could be costs for all bank customers.

The hidden costs to consumers

The costs to consumers could be felt both in financial terms and in the quality of choices available.

Where would FDIC insurance premiums come from?

Building a large enough insurance fund to protect deposits up to $10 million per account would require the FDIC to raise the insurance fees it assesses banks. Naturally, banks would pass those extra costs along to customers.

Banks could recoup these costs by raising account fees. They could also recoup them by paying lower interest rates on deposit accounts, even though interest-bearing accounts are not included in the new insurance limit.

The move to delay the increased assessments by ten years for some banks only creates other problems. It would mean promising insurance without fully funding it — a strange choice for a bill intended to make the banking system safer.

Impact on consumer choice

Accounts with balances over $250,000 are primarily concentrated in very large banks. Thus, these large banks would reap most of the benefit from the increase in the FDIC insurance limit. Their size also gives these large banks the economies of scale to best afford increased insurance assessments.

That means that if the bill is passed, it could favor large banks over small and medium-sized banks. To the extent this restricts the growth or viability of smaller banks, it could leave consumers with fewer banking choices.

Since the largest banks often pay relatively low interest rates and charge relatively high fees, this shift in market dynamics could hurt consumers.

How higher FDIC limits could increase banking risks

Critics of the proposal also argue that far from protecting the banking system, it could actually endanger it.

Notably, there have been only nine bank failures in the past five years. This represents just 0.2% of the more than 4,300 FDIC-member banks. However, in early 2023, two large banks failed within days of each other. Concerned that these failures might spark a run on other banks, the FDIC announced that it would cover even the uninsured deposits of those two banks.

No widespread runs on banks followed in 2023. However, some analysts caution that the FDIC’s decision to cover uninsured deposits may have set a dangerous precedent. People might expect the FDIC to do likewise for future bank failures.

What is a moral hazard?

A moral hazard is a situation where people have no incentive to behave responsibly because they believe they will be protected from the consequences. Critics argue that extending the FDIC limits above $250,000 created a moral hazard. The same argument has been made about raising the insurance limit well above the size of most accounts.

How higher limits could make banks less responsible

How could a higher FDIC insurance amount cause banks to behave less responsibly?

For one thing, banks might perceive an incentive to take more risks in lending and investments. If it turns out their assets can’t cover their deposits, the increased FDIC insurance limit would act as a backstop.

In turn, bank customers would have less need to worry about a bank’s management soundness. Thus, the marketplace would reward banks that offered the most attractive account terms, rather than those with prudent management.

Better alternatives for deposit protection

For practical reasons, a radical increase in the FDIC deposit limit seems unlikely to happen. Whether or not it comes to pass, there are more certain ways you can make sure all your deposits are safe:

• Spread your deposits across multiple banks if you see your total deposits at any one bank approaching the insurance limit.
  
• Be wary of bank subsidiaries. A bank may be operating under a different name, but if it is a subsidiary of a bank you have other deposits with, the total of those deposits will count toward the insurance limit. Always check if your bank has a parent company.
  
• Use U.S. Treasury investments for larger amounts of money. If you need to keep amounts above the limit safe and secure, consider using short-term Treasury securities for cash management. These are highly liquid and backed by the federal government, so they can perform much the same function as a bank account for larger amounts.
  

Red flags to watch for:

• Be wary of banks that are experiencing unusually rapid growth. Money that flows quickly into a bank can flow out just as quickly.
  
• Look up the bank’s disclosures in the FDIC’s BankFind Suite. Bank financials are complicated, but if you want to take a deeper dive, a basic place to start is with the ratio of the bank’s assets to its deposits. On average, U.S. banks have assets that are 25% more valuable than their deposits. Anything below may be less secure.
  
• Financial disclosures also include net income. Negative net income or a sudden decrease in net income is a warning sign.
  
• One detail you can look up in a bank’s financial disclosures is the value of a bank’s deposits that are above or below the $250,000 threshold. The industry average is for uninsured deposits to make up less than half of total deposits. If a bank is above that, it may be less stable.
  

Even if your deposits are fully insured, having your bank close suddenly is a nuisance. So, whether or not your deposits are safely below the FDIC-insured limit, it’s wise to be aware of red flags when choosing a bank.

Bottom line: The current FDIC insurance limit already protects most depositors

The current FDIC insurance limit already covers the majority of U.S. bank accounts. While proposals to dramatically raise that limit may sound reassuring, critics argue they could increase costs, reduce competition among smaller banks, and encourage riskier banking behavior. For most consumers, understanding how FDIC insurance works and structuring deposits accordingly is likely a more practical solution than expanding coverage far beyond typical account balances.