FDIC type deposit insurance is a joke.

In the UK, deposit insurance is funded by taxpayers, which equals a subsidy of banks. As the UK’s Vickers commission on banking rightly put it, “The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers.” So to that extent, deposit insurance UK style is a nonsense.
 
In the US, small banks are insured by the Federal Deposit Insurance Corporation, and the FDIC pays for itself: better than the UK system. However, even FDIC type insurance has logical flaws as follows.

 
Deposit insurance wipes out the profit from accepting risk.

The return demanded by savers and investors splits into two elements. First there is the reward required for abstaining from consumption. (Incidentally the market price for that “abstinence” is currently around zero: e.g. the return on near zero risk investments (e.g. German government debt) is around zero. But normally a positive reward is offered.)

Second there is the reward required for accepting risk. However if the chance of losing everything in any one year is X%, then the reward for undertaking that risk will be X% and the appropriate insurance premium will also be X% of the capital sum insured: the insurance premium wipes out the reward offered for accepting the risk! Or to be more accurate, the insurance premium MORE THAN wipes out the reward because insurers have administration costs and (in the case of private insurers) are in business to make a profit.  So FDIC type insurance is of little benefit to depositors, plus it does not result in banks being funded more cheaply. To that extent it’s a farce!

And it is not the job of the state to engage in farcical activities. But that’s not to say PRIVATE INDIVIDUALS should be barred from engaging in farcical types of insurance. E.g. if someone wants to insure their pet cat for a million dollars, there’s no reason to stop them.

Likewise, if people want to arrange PRIVATE insurance for their bank deposits, there is no reason to stop them.

 
The vast sums needed to fully insure bank deposits.

One of the alleged merits of FDIC type insurance is that it encourages people with money to spare to have their money put it into the real economy rather than simply lodge it with the central bank. That option of “lodging with the central bank” is available in the UK in the form of placing deposits with the state run savings bank, “National Savings and Investments”, and that facility is doubtless available in some other countries. Those deposits are not much different to keeping spare cash under the mattress. 

Now as implied above, there are two types of insured bank funders: first, shareholders and bond-holders who self-insure, and second, depositors who have FDIC type insurance.

But the FDIC option involves a destabilising flow of funds when a large bank fails. That is, the insurer has to keep large funds in some sort of liquid asset which is then sold when a large bank fails. Unfortunately, the sums needed when a large bank, and more importantly, a SERIES of large banks fail, are so huge, that the above destabilisation is arguably as bad as letting banks fold. That is, whatever liquid asset is involved, its value would crash when a large proportion of it was sold so as to fund the rescue of millions or billions of dollars worth of deposits which had gone west.

An alternative is for the insurer to hold VAST amounts of base money: a sum approximately equal to the total of deposits insured. But wait a minute: that involves having large sums doing nothing – exactly what deposit insurance is supposed to avoid! The whole thing is still a farce!

 
Cheating the insurer.
 
Another problem with FDIC type insurance is the temptation to cheat the insurer.  For example, if your car is insured against theft, that’s an inducement to take less care about locking it when leaving it unattended. 10% of car and house insurance claims in the UK include an element of fraud. Likewise, with FDIC type insurance, the bank will take bigger risks than where no insurance is offered.

Sometimes that inherent defect in insurance is a price worth paying. That is, insurance really comes into its own where the objective is to avoid total ruin, as distinct from reimbursing you in respect of a loss that you can easily carry without being ruined. Indeed, the fact that many insurance policies involve the insured party paying a so called “excess” (e.g. paying the first hundred pounds or two in the case of car or house insurance claim) is a recognition that insuring against SMALL LOSSES is a waste of time.

But if FDIC type insurance is abandoned, the result would be that the proportion of bank funding that comes from shareholders or quasi shareholders like bond-holders would rise. Indeed, if deposit insurance is abandoned than arguably ALL BANK FUNDERS ipso facto become shareholders: that’s shareholders as in “someone who at worst stands to lose everything”.

But if banks are funded largely or only by equity, they are highly unlikely to be “ruined” i.e. go insolvent. Ergo the above “avoid ruin” merit in FDIC type insurance is nothing to shout about.

 
Bank failure probably means too much has been loaned.

A final nail for the “FDIC coffin” is as follows. The mere fact of bank failure (and more important, a SERIES of bank failures) is an indication that too much lending has taken place, and hence that banks should shrink their operations. And that’s exactly what happens with a bank is funded just by equity: shareholders take a haircut, and there’ll be a reluctance to put money into banks for a while.

In contrast, given FDIC type insurance, depositors lose nothing. Thus after one bank has been closed down (normal FDIC procedure), depositors will then put all their money into another bank, safe in the knowledge that (again) they cannot lose, despite the new bank taking excessive risks or lending too much (assuming the bank industry AS A WHOLE has been lending too much).

In short, FDIC type insurance prevents a normal market mechanism working properly: the scaling down of an industry when the industry has grown too large.

 
Conclusion.
 
There is much to be said for abandoning deposit insurance. Instead, those who want total safety could lodge their money with the state or central bank. And as to those who want their money loaned on or invested, they’d accept the risks involved just as they do with stock exchange investments.

Indeed, if you lend to a corporation by buying its bonds, you accept the risk involved. But if you place money in a bank which lends to the same corporation, and it all goes wrong, you’re protected by deposit insurance. The logic eludes me.

If FDIC type insurance WERE abandoned, there would of course be an initial deflationary effect: people would withdraw money from the real economy and lodge it with the central bank or similar. But that deflationary or “demand reducing” effect is easily countered by standard stimulatory measures.