How Deposit Insurance Works

Recent bank failures have focused attention on deposit insurance. With the recent failures of Silicon Valley Bank and Signature Bank the FDIC ensured all depositors were quickly paid back in full. However, despite this outcome, deposit insurance only technically guarantees deposits up to $250,000, though there are exceptions for multiple beneficiaries and different account types.

Treasury Secretary Janet Yellen has stated that amounts over $250,000 will only be guaranteed for banks that pose systemic risk. That does imply that deposits of over $250,000 could still be at risk if the bank fails. Ironically, this was one factor in the collapse of Silicon Valley Bank because depositors with over $250,000 rushed to withdraw funds, causing a bank run, although the bank had already incurred paper losses. The Treasury is in a difficult position, on the one hand it wants to reassure depositors, but on the other it doesn’t want to reward banks for taking excessive risk or distort the incentives that banks face.

How Deposit Insurance Works

The Federal Deposit Insurance Corporation (FDIC) is at the heart of this issue, it was formed by the Emergency Banking Act of 1933. It was a response to bank failures during the great depression.

Bank Runs

One issue with banking is that a runs on a bank, where depositors rush to withdraw their money, can be sensible and can occur even if a bank is well-funded. That is to say if you see others withdrawing deposits from a bank, and your deposits are not insured, you should rush to withdraw your money too, otherwise you might lose it. Enough deposits withdrawing money can cause a bank to sell corresponding assets in a hurry, causing an otherwise robust bank to collapse.

That’s far from ideal, it means banks can collapse due to the snowballing emotions of the crowd, and it’s why deposit insurance was established. With deposit insurance if you have under $250,000 at a bank (this insured amount has steadily increased over time), then the government will pay you bank even if the bank collapses. Hence there’s no incentive for a bank run, at least not for depositors with under $250,000. That also helps explain the issues with Silicon Valley Bank, many start-up businesses had deposits of over $250,000 there.

Moral Hazard

However, there’s another risk too, this is what economists call moral hazard. If the government insures all bank deposits, then banks can potentially take on extra risks, knowing that their depositors don’t have to worry. That’s why banking is one of the most regulated sectors of the economy, and perhaps why deposit insurance doesn’t cover deposits over $250,000 today.

It’s also why Treasury Secretary Yellen has said that depositors with over $250,000 can’t expected to be paid back in all future bank failures, only those that pose systemic risk. That’s hard for depositors to assess, but has lead to migration of large deposits from smaller to larger banks over recent days, as larger banks are likely to be viewed as more systemically important, all else equal.

The last thing to note is that deposit insurance is not a bailout. All banks contribute a premiums to the FDIC over time, this provides the cash to pay out in the event of a bank failure. Deposit insurance is self-funded by the banking sector itself. The premiums banks pay are a reflection of the size of their deposits and the assessed risk level of the bank according to the formulas shown here.

Checking You Have Deposit Insurance

There are three basic steps to making sure that you have deposit insurance. The first is checking that your bank participates in the FDIC scheme. You can do that here, over 4,000 banks are insured. Importantly, note that credit unions are not FDIC insured, but do have their own similar scheme, the NCUA which also provides $250,000 of deposit insurance. Also the FDIC scheme only covers eligible U.S. institutions, though most other countries have similar schemes in place.

Account Types

The next is to make sure your account type is insured. Deposits are insured such as checking accounts, money market deposit accounts and certificates of deposit (CDs). However, other investment products that you can purchase based on an existing banking relationship are not. For example stocks, bonds, mutual funds, crypto, life insurance, annuities, the contents of safety deposit boxes and U.S. Treasury bonds and bills. These are not FDIC insured, even if you purchase them via a financial institution. This documentation associated with these products will contain terms like not guaranteed, subject to investment risks, risk of loss of principle and not insured by the FDIC.

Now, of course, investing with deposit insurance is not the only investment goal for most people, subject to risk tolerance and investment needs these products have often outperformed deposit returns over time, but with ups and downs along the way.

Multiple Beneficiaries and Banks

Then the final question is whether the full amount of your deposit is insured. If it’s under $250,000 and meets the two above tests then it should be. However, you may also be insured for over $250,000 if the account has multiple beneficiaries. since each beneficiary can be insured for up to $250,000. The $250,000 limit is essentially per beneficiary and per qualifying account type at the same bank. However, it then matters what other accounts those individuals also hold at the same bank. Also, different account types at the same bank can also be subject to individual $250,000 limits.

The FDIC offers a self-service online tool that enables you to calculate your insured total here. Finally, it’s worth noting that if you have deposits at different FDIC insured banks, each can be insured for $250,000.

Investment Strategies

Deposit insurance then leads to the following potential strategies. If you do have over $250,000 invested at an individual institution you can increase your insurance amount by spreading it across multiple qualifying account types, adding beneficiaries, such as your spouse or children, or moving the portion over $250,000 to another institution where you don’t have an existing deposit account.

Risk-Return Trade Off

Another strategy, ironically, is to move the amount over $250,000 into an asset with arguably a better risk-return trade-off depending on your circumstances. The issue with bank deposits is you earn a low interest rate over time, that’s a necessary trade off if you need the money at short notice. However, if you have a longer investment horizon and suitable risk tolerance you could consider investing the excess amount in stocks and bonds. That amount won’t be insured against losses and will see a dramatically different return profile to a bank deposit, but history suggests that diversified portfolios will tend to outperform bank accounts over decades.

What To Do

Ultimately, for most people with under $250,000 in a checking account FDIC insurance means they don’t have to worry about banking failures or the nuances of the deposit insurance rules.

Still, if you do have over $250,000 in a checking account or similar, it may make sense to evaluate your options during this period of potentially elevated banking risk, the way banking stocks are trading suggests there is still elevated risk out there. These events come along every few decades, but very large deposit balances in excess of $250,000 may carry a very small but potentially substantial downside risk with little corresponding upside from relatively low interest rates.