Bank issues

Regular and jumbo CDs, plus general customer deposits at banks are covered by FDIC insurance. The government requires banks to obtain FDIC insurance for their customers, which covers the loss of funds due to bank failure. Before we go further, let’s discuss how a bank can fail.

Banks receive deposits from customers, vow to protect and safekeep their money, and pay them interest. Then, the bank invests the majority of its customer deposits. Investments could include loaning those funds to other customers (e.g., small business or personal loans) or purchasing securities.

Let’s demonstrate this with an example using small numbers. Let’s assume ten customers give you $100 each, totaling $1,000 in overall deposits. You promise to keep their money safe and offer them a 2% annual interest rate*. To make money, you’ll need to invest most of those funds. On the other hand, you’ll want to keep some liquid cash on hand in case one or a few of your customers request withdrawals.

*For sake of simplicity, let’s assume the interest is paid directly to the customer and is not reinvested or compounded.

To be safe, you invest $600 of the $1,000 in deposits, representing a 40% reserve requirement* (meaning you’re not investing 40% of customer deposits). You place all $600 in “safe” long-term bonds.

*A 40% reserve requirement is quite conservative. Most banks today maintain a 10% reserve requirement.

All is going well in the first year, and you’re making a decent amount of money on your investments. You owe your customers $20 in annual interest (2% x $1,000), but assume you make $50 in interest received from your bonds in the first year. This demonstrates how banks make profits. They make “the spread” between the interest paid on customer deposits and the returns earned on bank investments ($30 in this example). Additionally, your original ten customers have yet to request withdrawals.

Things suddenly take a turn for the worse in the second year. Due to interest rates rising, the value of your bonds declines from its original $600 value to $400. Additionally, three of your ten depositing customers request total withdrawals ($300 total). While fulfilling their request, you seem anxious and tentative. What if your other customers pull money out as well?

Word spreads about your tense encounter with the three customers. The following day, six of the remaining seven customers request complete withdrawals totaling $600. This is a huge problem! Let’s account for the money up to this point:

• +$1,000 in original deposits
• +$30 in first-year profits
• -$200 loss on government bonds
• -$300 in withdrawals (first three customers)

Total assets = +$530

Your remaining customers are requesting $600 in withdrawals when you only have $530 at your disposal. On top of that, $400 of the $530 is tied up in long-term bonds. All you can do is liquidate the bonds to free up some cash, locking in the $200 loss ($600 original value vs. $400 sales proceeds). Unfortunately, you still don’t have enough money to fulfill customer withdrawal demands. Here’s the final accounting:

• +$1,000 in original deposits
• +$30 in first-year profits
• -$200 loss on government bonds
• -$900 in customer withdrawals ($300 + $600)

Total = -$70

A bank failure occurs when customers request withdrawals exceeding the amount of liquid cash the bank maintains. The example above is a basic version of this situation. In the real world, bank failures can amount to billions in losses (e.g., the Silicon Valley Bank failure in 2023). The two leading factors are almost always the same - bad bank investments and a “run on the bank” (many customers request withdrawals at once).

FDIC insurance protects bank customers from these situations. Without this insurance, customers could lose some or all their money if their bank failed. FDIC insurance covers customer deposits up to $250,000 per bank on a per-customer / per-ownership-category basis. For example, let’s assume an individual maintains the following accounts:

• Individual savings account with $250,000
• Individual checking account with $250,000
• Joint savings account held with spouse with $500,000

If the individual’s bank failed, they would gain coverage for $750,000 total: one instance of $250,000 coverage for the two individual accounts (they’re combined since they are held by the same customer) and coverage of 2x $250,000 = $500,000 (individual + spouse, each co-owner counts) for the joint account. The per-customer coverage will only provide a single coverage to accounts owned by the same party, but a separate coverage is provided when a new customer (e.g., the spouse) or ownership category is involved.