What Does the FDIC Do? Part One - Insure Deposits

I just heard a clip from the Clark Howard show while driving home from the store. If you don't know who Clark Howard is, he's a radio talk show host whose forte is the common man's economic adviser. His shows will discuss when the best time is to buy Christmas gifts to get the best deals, or what web site to look at to determine which auto or life insurance is rated the best or most sound. He gives advice about how to contact a VP of a company when the "no-service" department won't help you. He warns about Nigerian email scams and how a 529 College Savings Plan works and which state gives the best deal.

I turned on the radio after the caller had asked her question, but Clark's answer made it clear that he was explaining why the FDIC had to insure deposits. When he explained that the bank does not keep your exact money in a drawer in a vault but lent it out to other borrowers, the caller - who sounded like a woman in her 60s - audibly gasped "Oh my!".

It was obvious that she didn't know what banks do with her money and she had called into the station upset about the bailout and increased FDIC limits.

I was so shocked that she thought that banks kept her money separate from everybody else until she needed it, that I decided that I needed to write and explain what the FDIC does.

What Happens to Your Money

A woman, let's say Sarah, gets her paycheck for $1000. She works for Sam, who manufactures hardware parts for wholesale to hardware stores. The paycheck is written on Bank of Z (hereafter "BoZ") but she's going to open up an account at Bank of A ("BoA"). In fact, it turns out that she will be the very first customer of BoA.

She opens her account by depositing the full $1000 check. In a another post we'll talk about the check, but for now she has a checking account with a balance of $1000.

Bob just opened the local hardware store. He goes to BoA to get a loan to buy inventory from Sam the hardware manufacturer that Sarah works for. BoA only has $1,000 in it's accounts. By law, set by the Federal Reserve, BoA must keep 20% of their deposits in hand to give customers petty cash, and so forth. So they can lend $800 out.

They need to lend some money out because they have to make money to pay their employees and pay for the checking operations center they had to set up to handle Sarah's check. So they lend $800 to Bob for 10%. They will make $80 on the loan and maybe Bob will be successful and deposit more money there.

Bob deposits the $800 in his account. The bank now has $1800 of deposits. Sarah's $1,000 and Bob's $800. They can now lend out another $640 - 80% of 800 to another customer. The total of all customer's accounts is $1800 BUT THERE IS ACTUALLY ONLY $1000 IN THE ACCOUNTS OF BOA!

Now let's make this real, real simple.

Let's assume there is no FDIC insurance for BoA. That afternoon, both Sarah and Bob hear a rumor that BoA is going to fail. They both race to the bank. Bob gets there first and takes out his $800 because he's already ordered inventory from Sam and he needs to be able to pay him.

When Sarah gets there to withdraw her $1,000, the bank says "We're sorry, all we have is $200". She's says I need $750 today or I'll default on my mortgage. Sarah is very upset and calls all her friends and relatives and tells them her terrible story about how she lost $800. She tells them they had better take their money out of their accounts too. They say, "Well, we don't bank at BoA!" But what she says scares them, so they call each other and say "Maybe we'd better take our money out of BoZ". Soon the rumor spreads that there is a run on BoZ and everybody had better get their money now.

But at least Sarah still has her job at Sam's the Hardware manufacturer. Next week, she'll cash her check and pay the mortgage and a late fee and will be okay.

But by the next day, there has been a terrible run on BoZ by Sarah's family, friends, and their families and friends. BoZ has given out all their money and closed it's doors. Many, many people have lost a lot of money.

In fact, Sam was supposed to deliver $800 of inventory to Bob. He has $400 of inventory on hand but he needs to purchase more raw material to make the other inventory that he has promised to sell. But with the closure of BoZ, Sam doesn't have enough money to purchase the raw materials.

In fact, he has to lay Sarah off and tell her he can't give her a paycheck this week. He asks her if she would like to take some wire spools, plywood, or left over hammers to make up for no paycheck. She rightly says, "what am I going to do with those?"

Meanwhile, Bob opens his business with the $400 of inventory he did get. Unfortunately, so many people have lost their money and jobs that his business is poor and he shuts his doors.

With the FDIC Insurance

This is the way it was for years in the 1800's and up until the FDIC was created in 1933 and 1934. Now all banks pay an insurance premium to cover their accounts up to $100,000 per person.

In the above scenario, this would have happened:

Bob and Sarah would have heard the rumors of BoA's insolvency and probably ignored them because they were insured by FDIC.

But if they had made a run on the bank, the FDIC would have come in and taken over the bank. They would have "sold" the good parts of the bank to say BoZ. BoZ wanted new depositors and the lending business that BoA had.

This is important and a little more complicated.

BoZ would have paid a premium for the good assets of BoA. Let's say for the 2 accounts of Sarah and Bob - a total of $1800, and $1800 from the FDIC, they would have paid $100 premium. Since BoA only has $1000 in it, the FDIC has to chip in $800 (less the $100 premium they get from BoZ) to transfer the accounts to BoZ.

So far, it only cost the FDIC $700 and Sarah, Bob and BoZ are all happy and the other bank didn't fail and Sam bought the extra raw material and made the parts for Bob who the sold them to the people who still had their jobs, who bought from Bob's hardware, who hired some help, etc., etc.

(Not discussed is any bad loans that BoA has. BoZ can refuse to take them and the FDIC will probably pay BoZ to service them or they will sell them at pennies on the dollar to a loan wholesaler who will try to collect on them, so the FDIC will pay more than $700 but you get the idea.)

CONSERVATIVES: HERE'S MY POINT: THE FDIC IS LIKE AN ANTIBIOTIC SHOT WHEN YOU GET SICK. The fat cats generally get fired. It is not bailing them out, it is bailing Sarah, Bob, Sam, your neighbors and you out. Our economy only works when it is flowing. When it stops, people who want to work and do right, can't.

Otherwise we go back to keeping gold coins buried in the yard and hope that thieves don't steal our life savings.

NYT story on new deposit limits here.