Depositors as a Source of Market Discipline

Abstract

The failure of many savings and loan institutions in the 1980s bankrupted the Federal Savings and Loan Insurance Corporation (FSLIC), forcing the FSLIC to rely on massive federal subsidies. A similar crisis subsequently struck the banking system, and it now appears that the Federal Deposit Insurance Corporation (FDIC) will also go bankrupt and require taxpayer subsidies. The vast expense of these bailouts has focused the attention of policymakers and the public on reducing the risk exposure of the federal deposit insurance system. In response to this crisis, the U.S. Treasury issued a report in 1991 in which it made specific proposals for reforming deposit insurance. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) incorporated some of the Treasury Department's proposals. One controversial element of the FDICIA is a plan for reforming the deposit insurance system by shifting some of the risk of bank failures from the federal insurance fund to depositors themselves. This proposal rests on the premise that depositors who bear some of the risk of bank failure are likely to discipline weak institutions by threatening to withdraw their deposits. In this Article, Professor Mantripragada discusses the costs and benefits of depositor discipline and assesses the Treasury proposals and FDICIA provisions that are designed to promote depositor discipline. The author suggests that a maturity-based coverage limit would be preferable to the dollar-based limit retained by the Act.