What Is Risk-Based Deposit Insurance?

Risk-based deposit insurance is insurance with premiums that reflect how prudently banks act when investing their customers' deposits. 

The idea is that flat-rate deposit insurance shelters banks from their true level of risk-taking and encourages poor decision-making and moral hazard. With risk-based deposit insurance, on the other hand, banks might think twice about behaving recklessly as those who take on more risk are required to pay higher insurance premiums.

Key Takeaways

  • Risk-based deposit insurance is insurance with premiums that reflect how prudently banks act when investing their customers' deposits.
  • The Federal Deposit Insurance Corporation (FDIC) insures member bank deposits so that customers won't be left empty-handed if a bank fails.
  • The idea is that flat-rate deposit insurance shelters banks from their true level of risk-taking and encourages poor decision-making and moral hazard.
  • With risk-based deposit insurance, meanwhile, banks might think twice about behaving recklessly as those who take on more risk must pay more.

Understanding Risk-Based Deposit Insurance

Risk-based deposit insurance became standard after the Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991. During the savings and loan crisis, nearly one-third of the 3,234 savings and loan associations in the United States failed, prompting regulators to change tact and switch from a flat-rate deposit insurance system, in which premiums were set at a uniform rate across all banks, to a risk-based assessment arrangement.

The FDIC switched to variable risk-based premiums in 1994 for banks and in 1998 for savings institutions.

The FDIC, an independent federal agency whose primary purpose is to prevent a repeat of the run-on-the-bank scenarios that caused havoc during the Great Depression, uses the deposit insurance premiums it collects from banks to fund the Federal Deposit Insurance program. This program protects consumers by covering deposits of up to $250,000 at member banks in the event that they fail.

Checking accounts, savings accounts, certificates of deposit (CDs), and money market accounts are generally 100% covered by the FDIC, as are cashier's checks and money orders issued by the failed bank. Coverage extends to trust accounts and Individual Retirement Accounts (IRAs) too, but only to the parts that fit the type of accounts listed previously. 

Products not protected by FDIC insurance include mutual fundsannuities, life insurance policies, stocks, and bonds, as well as the contents of safe-deposit boxes.

Benefits of Risk-Based Deposit Insurance

Risk-based deposit insurance was designed to stomp out reckless banking and put a stop to moral hazard: a situation in which one party to an agreement engages in risky behavior or fails to act in good faith because it knows the other party bears any consequences of that behavior. 

Risk-based deposit insurance is believed to play an important role in preventing banks from failing due to reckless behavior, namely by requiring those with higher risk exposure to pay more expensive insurance premiums.

Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking, which results in them paying more in claims. Risk-based premiums were supposed to discourage such behavior by forcing banks to face the true cost of risk.

Limitations of Risk-Based Deposit Insurance

Risk-based deposit insurance isn’t necessarily a flawless solution to mitigate moral hazard. Its effectiveness hinges on the deposit insurer’s ability to fully observe and comprehend the risk characteristics of a bank’s investment portfolio, a task often riddled with challenges.

It's reasonable to assume that an outsider could struggle to properly evaluate all activities a bank is undertaking and get to grips with the dangers associated with some of its more complicated products. Should this be the case, the premiums charged may not adequately reflect the risk the bank is taking on, potentially leading the risk-based deposit insurance to fail in its mission to control moral hazard.