The FDIC used to charge all banks the same rate for insurance on deposits. From what you have learned, what problems did this create for not only the FDIC but for well-run banks?

Question

What will be an ideal response?

Answer 1

For FDIC the immediate problem is adverse selection. The average rate would have attracted more low quality, or in this case, high-risk banks. Now the FDIC could get around the adverse selection problem by simply asking for a regulation requiring all banks to purchase insurance through them. This is similar to an insurance provider providing group insurance to an employer but insisting the employer get most if not all of the employees to purchase coverage and it not be voluntary. The FDIC cannot escape the problem of moral hazard, however; here the presence of insurance will have some banks wanting to take on more risk. In fact, the well-managed (low risk) banks will be at a disadvantage, actually subsidizing the high-risk banks. The only way to address the problem of cross-subsidization is through a premium that is risk based so that the lower risk company will pay a lower premium, which would in theory allow it to offer lower rates on loans and or higher rates to depositors.