FRB Commentary 2: Deposit Insurance

Banking and Money

Banking 1
Banking 2: A bank's income statement
Banking 3: Fractional Reserve Banking
Banking 4: Multiplier effect and the money supply
Banking 5: Introduction to Bank Notes
Banking 6: Bank Notes and Checks
Banking 7: Giving out loans without giving out gold
Banking 8: Reserve Ratios
Banking 9: More on Reserve Ratios (Bad sound)
Banking 10: Introduction to leverage (bad sound)
Banking 11: A reserve bank
Banking 12: Treasuries (government debt)
Banking 13: Open Market Operations
Banking 14: Fed Funds Rate
Banking 15: More on the Fed Funds Rate
Banking 16: Why target rates vs. money supply
Banking 17: What happened to the gold?
Banking 18: Big Picture Discussion
The Discount Rate
Repurchase Agreements (Repo transactions)
Federal Reserve Balance Sheet
Fractional Reserve Banking Commentary 1
FRB Commentary 2: Deposit Insurance
FRB Commentary 3: Big Picture
LIBOR

FRB Commentary 2: Deposit Insurance More on the weaknesses of fractional reserve banking. The FDIC and deposit insurance and its side effects.

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FRB Commentary 2: Deposit Insurance

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In the last video, I touched on the core weakness of
fractional reserve banking and that's the idea of the bank
run-- where if you have a bunch of banks and they've all
lent out 90% of their reserves-- let's say that
here's all my banks-- Bank One, Bank Two, Bank Three--
and you could have a ton of banks.
I mean, you could imagine you go all the way to Bank 100.
The problem with a bank run is if just even one bank all of a
sudden isn't able to give its depositors its money-- so it
is illiquid-- and we'll reserve judgment as to whether
it is truly insolvent, but it really just doesn't have the
money to give it to depositors, then all of the
depositors of all of the other banks get scared and run over
to the banks and ask for their money back.
And by definition, in a fractional reserve banking
system, these guys only have 10% of their deposits as
reserves, 10% reserves.
So if more than 10% of the people ask for their money,
they're all going to be illiquid.
Then you're going to have just an all-out panic.
You're going to have an all-out panic of
the financial system.
As soon as any of these guys' loans come due-- so let me
draw one of their balance sheets-- let's assume that
they were actually good investors, which is a big
assumption, but let's say that their balance
sheets look like this.
Here's all of the deposits that they owe to people-- to
me and you.
That's their liabilities.
They have 10% of their assets as actual currency reserves.
And then the rest is loans out to businesses
and whatever else.
And that's an asset because businesses owe them something.
And what's going to happens-- as soon as there's a panic,
everyone wants their money out.
The reserves are depleted very quickly.
And then these guys sit there waiting for their money.
Essentially it shuts down the bank.
As soon as these loans mature-- maybe this guy owed
his money in a year.
Then they're going to say, just give me the money back.
I'm not going to renew the loan even though you have a
good business.
And so everyone's going to want their money back and the
whole financial system's going to break down and credit is
going to freeze.
And this is a huge problem.
Remember, this could be just because by one bad actor who
couldn't manage their liquidity properly.
Even worse, it could be caused just by one panicky
withdrawer.
There's doesn't even have to be a bad actor.
It could just be some fear that enters the system-- and
even for a completely legitimate bank-- and I'll use
legitimate in quotations because we're assuming
legitimate-- because some would debate whether
fractional reserve banking is legitimate.
But even if this is a completely up-and-up bank, if
for whatever reason more than 10% of their deposits get
scared, then all of a sudden they'll be illiquid and you'll
be in this all-out panic condition.
Now I talked in the last video, some of the things that
have been engineered to fix this problem.
So these are the fixes.
The first one is to have a banker of last resort, a
lender of last resort.
And that's our central bank-- or the Federal reserve bank.
And they'll never run out of reserves, because these
reserves can be borrowed from them and all these are, are
IOUs from the Federal reserve.
So what the Federal reserve does-- and I've talked about
this in the past-- let's say that their balance sheet
currently looks like this.
Let's say that this is their current liabilities.
These are their current assets.
And their current liabilities are
essentially going to be IOUs.
These are going to be their reserve notes, but let's say
someone else comes and says, hey, federal reserve, lend me
some money.
So what they're going to do is that they're going to print
some-- so these are Federal reserve notes.
And then they're going to just create an offsetting liability
and they have no reserve limits.
Let me make it a new color just to ease the monotony.
So they'll have this corresponding notes
outstanding liability and they're going to give those
notes to you.
They're going to give those notes to the bank that's in a
desperate situation if it couldn't borrow
from any other bank.
And so the Federal reserve balance sheet will
now look like this.
This is what it looked like before.
It has these new notes outstanding and now this will
say-- instead of federal reserve notes in its vaults,
it'll now have this little thing on its books called loan
to the bank, loan to this guy right here, which is an asset
because he owes him something.
And there's no limit to which the Federal
reserve could do this.
Obviously there might be some kind of implicit limit.
If they keep doing this arbitrarily, people might not
accept these Federal reserve notes as
actually carrying value.
So that's probably the main limiting concern.
And I'll probably talk more in future videos on other things
that are kind of keeping the Federal reserve from just
doing this willy-nilly, but the general idea is that they
never run out.
So this is one idea-- lender of last resort, but not even
the Federal reserve wants to keep doing this because what
if this guy is essentially insolvent?
If these loans are actually going bad, then there's no
reason that even the central bank should actually be
lending to this guy.
They shouldn't be lending to this guy.
So let's say the Federal reserve looks at this guy's
books and say, you know what?
These loans are really worthless.
I'm not going to lend more money to you.
What I'm going to do is take you into receivership.
And I haven't even talked about what that is.
That's the second fix.
The second fix is to have this notion of insurance, of
deposit insurance.
So if a bank just has a liquidity problem-- it's a
good bank-- it just ran out of reserves and no other bank is
willing to lend to it-- which you might debate whether it's
even a good bank if the other banks aren't willing to lend
to it-- then it can go to the discount window at the Federal
reserve and borrow some reserve notes.
Now, in the situation where even that's not good enough
and the bank is essentially out of business, it had been
paying the FDIC a little bit of money-- the Federal Deposit
Insurance Corporation-- a little bit of money-- I mean,
probably a lot of money by an individual's point of view,
but a little bit of money from a bank's point of view-- and
it's a fraction of a percent-- a little bit of money every
year so that it could tell its depositors, look, even in the
situation that our bank goes bust, the Federal reserve is
going to pay you directly.
These are FDIC bank accounts.
The Federal reserve will make you whole completely,
regardless of what happens to the banks.
Now this, to me, is a big fix.
I mean, I'll tell you right now, all of my savings right
now are in Federal deposit insured-- FDIC
insured-- bank accounts.
This might sound great to the depositor, but what's the side
effect on the banking system?
Let me draw all of my banks again.
So I have Bank One, I have Bank Two, I have Bank Three, I
have Bank Four.
Now, they are all FDIC insured.
They pay some small fraction of a percentage every year so
that they can tell their depositors, look, if we ever
go bust, if we ever blow up for whatever reason, your
deposits are 100% safe.
And what's going to happen?
This will solve the bank run problem, right?
Let's say for whatever reason this guy runs out of reserves
or he goes bankrupt-- let's say that
this guy goes bankrupt.
In the old situation, before the insurance, everyone else
is going to get scared and you're going
to have a bank run.
They're going to ask for their money and there's just not
going to be enough reserves because they only keep a
fraction of the reserves.
That's what fractional reserve banking is, but now everyone's
going to feel comfortable, like, you know what?
Everything is backed by the Federal reserve, which can
print as many notes is it wants so I'm just
going to sit pretty.
So this does solve the bank run problem.
And so you might say, this doesn't make it an unstable
equilibrium any more-- which is kind of true, but
what does this do?
All of these guys are now FDIC insured.
I'm equally willing to give my money to any of these guys.
So I'm going to essentially going to give my money to the
guy who gives me the highest interest. And I've actually
done that with my personal accounts.
I've gone and I've seen which bank provides the highest
interest and I've ignored how they're investing their
money-- I mean, otherwise I'd be pretty suspicious about a
bank offering more interest because they're probably doing
something risky, but now I don't care because I know it's
FDIC insured and even if that bank blows up, I'm going to
get all my money back.
So I might as well give my deposit to the bank with the
highest interest.
Now based on what you saw in that last video, which is the
bank that's going to be giving the highest interest?
What's going to be the bank that's
taking on the most risk?
So once again, when you give this relatively cheap
insurance to all of these banks and all of these banks
can attract money much easier by paying this insurance-- if
they didn't have this insurance, they would have to
pay much more.
Let's say this insurance is 0.1% per year.
If they didn't have this insurance, they would have to
pay much more than 0.1% per year to the depositor in
interest to make up for the risk that they're taking on,
that they're not being backed by the government.
So it's a really good deal for the depositor.
Let's put it this way.
When you give a deposit to a bank, you're lending
money to the bank.
So your checking deposit rate-- so let me write this
down-- your checking deposit interest rate is the same
thing as the bank's borrowing cost, right?
When I go to some bank and they're paying me 2% a year,
that's the bank's borrowing cost. They're the same thing.
Now if the bank didn't have FDIC insurance, it wouldn't
have to pay 0.1% a year, but it would have to give me more
interest. It would have to pay me 3% or 4%, probably more,
because I'd say this is a risky bank--
or it's more risky.
Any bank would be more risky than someone who can
print out the notes.
So it would have to pay more, but now it can just pay 0.1% a
year or whatever the Federal Deposit Insurance Corporation
pays it, but it's going to lower to FDIC, but the main
side effect of this is it's going to lower what it has to
pay the depositors because the depositors say, this is a lot
safer than what I thought.
So it's going to lower borrowing costs by
much more than 0.1%.
So it's a really good deal for the bank and it's an
especially good deal for the ultra-risky banks who might
have to pay a little bit more, but because they can now do
super duper risky things.
You say, hey, but this is insurance.
The Federal Deposit Insurance Corporation isn't stupid.
It should just charge more for riskier banks.
But I guess the rebuttal to that is that's easier said
than done because when times are good, like in the '20s or
during the housing bubble, you get hidden risk.
So you don't know who's taking on the risk.
It's usually the person who's getting the highest returns,
but if they're always good for it, you don't see it and that
person just looks like a genius.
And then when times are bad, that guy blows
up, but guess what?
He's not on the line for it.
It's the Federal Deposit Insurance Corporation, who all
along was probably
undercharging for that insurance.
I want to make one last point about this.
It's called insurance.
It's the Federal Deposit Insurance Corporation.
And I want to point out the difference between financial
insurance-- and you could watch my video on credit
default swaps, which is another form of financial
insurance-- between financial insurance and what we normally
associate with insurance.
If I have car insurance-- let's say I'm a car insurance
person and I agree-- let's say that they are Driver One--
let's say I have a bunch of drivers-- so Driver One,
Driver Two, Driver Three, Driver Four.
And I know that in any given year, they each have a 10%
chance of an accident.
That's a lot higher than reality, but we'll make the
numbers easy.
And if there is an accident, it will cost me $10,000.
So I could go to Driver One and say, look, there's a 10%
chance you're going to have an accident.
It would cost $10,000 if you do.
So I'm going to charge you-- the fair
price would be $1,000.
I'll charge you $1,100.
I'll charge $1,100 just so I can make a little bit of a
profit, right?
What you would charge is $1,000 if you wanted to break
even, but I'll charge $1,100-- and I might do this more than
just four drivers.
I might do it with 4,000 drivers.
So on average in any given year-- let's say I have one
million drivers-- in any given year, how much am I
going to bring in?
I'm going to bring in a million times $1,100, which
is-- I'm going to get $1.1 billion in input, or in
revenue, from people paying their premiums. And how much
am I going to have to pay out?
Well, roughly 10% if you believe these statistics are
going to have an accident.
So that means that 100,000 are going to have an accident.
Each of those 100,000 accidents are
going to cost me $10,000.
$10,000 times $100,000.
I'm going to have to pay out $1 billion for the accidents.
So I will net every year-- if my actuaries did their job, I
will net $100 million every year.
And this works out pretty good assuming these statistics are
right and people are willing to pay the premium because if
you have enough drivers-- like a million drivers-- the
statistics really hold.
In any given year, the chance of 20% of the drivers having
an accident is very, very, very-- almost
infinitesimally small.
It's almost zero.
And one driver having an accident doesn't make it more
or less likely that another driver will have an accident
when you're talking about on the order
of a million drivers.
And that's true of health insurance and everything else.
It's just purely probabilistic and if you have enough people
insured, the statistics can actually hold up.
Now with financial insurance, you
have a different situation.
You might say, look, in any given year, on average, the
FDIC might say, look, only-- I don't know-- one out of out of
1,000 banks fail.
So there's a 0.1% chance of failure.
Of course it'll capture back some money because it'll have
some assets on average.
But the reality is that when times go bad, the bank
failures tend to be correlated because they're all
interlinked.
And I've done a lot-- one might be lending to some
business that's dependent on some business that this guy's
lending to.
The whole financial system is all linked up.
So the failures aren't-- they all correlate with each other.
They're not independent events.
So if one bank fails, it's much more likely that other
banks are going to fail all at the same time and we're
experiencing that right now.
So you can't really follow the insurance model because the
statistics really don't apply.
You can do this insurance model when each of the events
that you're insuring are uncorrelated, but when all the
events that you're insuring are likely to all happen at
the same time, what you're going to have is-- when times
are good, you're going to see a much lower kind of loss rate
and then when times are bad, all of your guys are going to
blow up and you're essentially on the hook
for all these people.
We see that right now and the FDIC is actually-- it's going
to have to go back to Congress, I'm 100% sure, and
ask for more money and it's we the taxpayers that are going
to be on the line for this type of thing.

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