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. Although not all bank failures are the result of moral hazard, risk-based deposit insurance is thought to prevent bank failures. Banks that have a higher risk exposure pay higher insurance premiums.

BREAKING DOWN Risk-Based Deposit Insurance

Risk-based deposit insurance became standard after The Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991 passed in the aftermath of the Savings and Loan Crisis. It required the FDIC to switch from a flat-rate deposit insurance program by 1994.

The FDIC, the primary purpose of which is to prevent run-on-the-bank scenarios that devastated many banks 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 insuring deposits of up to $250,000 at member banks in the event of bank failure.

Checking accounts, savings accounts, Certificates of Deposit (CDs) and money market accounts are generally 100% covered by the FDIC. Coverage extends to trust accounts and Individual Retirement Accounts (IRAs), but only the parts that fit the type of accounts listed previously. FDIC insurance does not cover products such as mutual funds, annuities, life insurance policies, stocks or bonds. The contents of safe-deposit boxes are also not included in FDIC coverage. Cashier's checks and money orders issued by the failed bank are covered.

Examples of Moral Hazard

Moral hazard is 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. Moral hazard is usually applied to the insurance industry. 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.

In business, common examples of moral hazard include government bailouts. In the late 2000s, during the throes of the global financial crisis, years of risky investing left many large U.S. corporations in peril. Ultimately, the U.S. government deemed some of these companies too big to fail and bailed them out. The reasoning was that allowing businesses so important to the economy to fail could push the U.S. into a depression.

The Dodd-Frank Act of 2010 attempted to mitigate some of the moral hazard in too-big-to-fail corporations by requiring them to design plans for how to proceed if they got into financial trouble.