The FDIC attempts to universalize risk in banking. Regardless of whether or not you even deposit money in a financial institution, whether or not you discriminate between different banks and the practices thereof, we are forced into subsidizing risk through government deposit insurance. The FDIC normally guarantees deposit insurance up to $100,000, while the insurance temporarily covers $250,000 of deposits until 2013. It does not take much to realize that bank management will make different decisions, pursue riskier ventures, and accept less financially-qualified clients if they know the FDIC has their back. The moral hazard that comes with the FDIC is undeniable.

The main flaw with the FDIC and the current banking system is that the control does not lie with the individual. Government’s history in banking has amounted to protecting banks, offering special and unnatural privileges to financial institutions (what other industry has a “lender of last resort” and a government program to help pay for risk?), and diminishing the regulatory power of the individual. A free market encourages and generally requires individual initiative, research, and understanding of the product, all of which the FDIC has assumed as its proper role.

What other industry needs a government agency to fall back on if they make unsustainable and irrational decisions? The truth is that the FDIC’s role is nothing more than to bail out bad management decisions and an inefficiently run business. Can you imagine what such a system would have done to an industry like technology? Tech companies would have much less incentive to improve their products if they knew they had the federal government guaranteeing major consumer losses.

By attempting to cover different risks in banking, the FDIC removes the incentives of banks to avoid those risks. It removes the incentive for individuals to scrutinize their potential banking options more carefully. If you know that all or the majority of your deposit is insured by the government, why bother with the details of bank management, financial health, etc.? Like economist Peter Schiff said, people spend more time researching a toaster than they do opening a bank account.

The FDIC’s softening or total removal of incentives to avoid and search for risk also slows the development of other options to banking. The amount of banks and the style with which they operate has not significantly changed since the FDIC came into existence in the 1930s. Nearly any other industry you can think of has undergone some major changes in operation over the past seventy years, while banking is essentially the same.

The FDIC locks people and businesses into a certain style of banking. (What banks and individuals wouldn’t want government guarantees of deposit insurance?) This may be fine and dandy for a time, but it stalls the development of what could be much more sustainable and sensible financial options for individuals, such as credit unions. With government regulators and bureaucrats calling the shots, rather than the free individuals of the country, new developments that would better serve the individual have been heavily limited and discouraged.

The slightly hilarious part is that in the event of a true banking meltdown, the FDIC wouldn’t have near the amount of necessary funds to ensure depositors got their money back. According to the FDIC’s own website, they manage an “insurance fund” of more than “$52.8 billion,” yet the agency “insures more than $4.3 trillion of deposits in 8,494 U.S. banks and thrifts.” Let’s see… $52.8 billion of funds to cover $4.3 trillion of deposits. Yes, the FDIC carries enough cash to cover a whopping 1.23% of the total deposits that it claims to insure.

The FDIC does not expand the power of the individual to make his own choices in the marketplace; it builds corporate loyalty to government standards, not individual standards. The problem with the banking system to begin with was the neglect of the individual’s regulatory abilities, the FDIC is simply an expansion of that unfortunate trend. The folly of the modern banking system is that it does not encourage individual initiative, research, and involvement in banking as a free market system would.

Rather than encourage free and alternative choices like individual deposit insurance plans, community credit unions (where individuals have a stake in where their deposits are spent), or discretion as to where one saves or invests their hard-earned money, we have consistently moved toward a centralized, bureaucratized, planned banking system. Such a system makes it extremely difficult for individuals to effect real change with their own local regulatory power, and prevents a truly sustainable and involved financial industry from coming about. Only the free market can guarantee a system swayed not by the government, but by free men and women exercising their ultimate regulatory authority as individuals.

• Click here for Part 1.

When the Federal Reserve was signed into law in 1913, it was largely on the basis that the independent organization would assume the role of “lender of last resort” to struggling banks and institutions. This would allow the Fed to extend credit in order to prevent short-term economic hardships. As I wrote in my article, Deception in “Free Market” Banking, banks had not experienced troubles because of the free market as is regularly assumed, but through the government-protected fractional reserve system that allowed banks to overextend themselves and deceive depositors:

After the Panic of 1907 and the umpteenth failure of fractional reserve lending, the attacks still were not aimed at the fractional reserve system. This system, when protected through law, gave banks the undoubted opportunity to inflate the money supply, overextend themselves in ways that would never be sustainable in a free market economy, and give little regard to the customers’ original property. Instead, economists began calling for a “lender of last resort” to bail out banks if they were caught overstretched in commitments. Many people don’t realize it, but the U.S. financial system has been in bailout mode for nearly a century since this event.

The Federal Reserve’s “last resort” lending powers did not meet the expectation of politicians. Banks still overextended themselves with depositors’ money despite the new powers of the central bank. In fact, between 1921 and 1929 there was an average of 600 bank failures every year, which exceeded the previous decade’s average (the one in which the Fed was created) by ten times.

During the last few months of 1930 people grew increasingly weary and cautious of the banking system. Understandably, people did not react well when they realized the banks did not have their deposited money. Banks retracted credit and liquidated assets, building up a financial perfect storm that resulted in 9,096 banks suspending operations between 1930 and 1934.

Many politicians reacted by proposing a system (that had been discussed in recent years) of deposit insurance backed and paid by a federal agency, despite the failure of similar state setups of deposit insurance in the same era. Since the early 1800s many states had attempted to offer some form of deposit insurance, many failing to live up to their initial claims. All of them were broke by 1930 (some reached their demise many years earlier, such as Michigan, New York, and Vermont in the mid-1800s).

This all changed when The Banking Act of 1933 was signed into law by Franklin D. Roosevelt on June 16, 1933. The Federal Deposit Insurance Corporation (FDIC) was established as a temporary agency that started operating on January 1, 1934. In its first year the FDIC fund carried a balance of $292 million. In 1935, with President Roosevelt’s signing of The Banking Act of 1935, the FDIC was established as a permanent government agency.The act also strengthened the Federal Reserve Board of Governors, the group of seven individuals who play a major role in controlling monetary policy.

The primary functions of the FDIC include insuring deposits through the Deposit Insurance Fund (DIF) and examining/supervising “financial institutions for safety and soundness and consumer protection.” This has been the basic mission of the FDIC in its 75 year existence, the details of which I won’t fully cover in this article.

Modern economics and politics often praise the development of the FDIC as a great and necessary banking program (this alone might be reason enough to question the FDIC’s role). The main curiosity that I have is the fact that rather than recognize the failure of a government-protected banking system that had failed numerous times leading up to the Great Depression, politicians decided to once again prop up the government system. According to information on the fdic.gov website, the original FDIC legislation drew support from those “who were determined to end destruction of circulating medium due to bank failures and those who sought to preserve the existing banking structure.” (Emphasis added.) These people either failed to realize or downright ignored that it was precisely the banking structure of the fractional reserve system that made such booms and busts so dreadful.

The failure of many banks in the Great Depression was not due to the free market. Fractional reserve banking, the process of banks loaning and investing more money than they actually have in reserve, had been shot down by market forces many times throughout the 1800s in the U.S. The numerous “financial panics” of the 19th century that people often pin on the free market would not have been possible had the states and federal government ceased in protecting the ability of banks to deceitfully loan away depositors’ money. A free market system would not involve government protecting banks in this process, but enforcing the distinction of contracts between demand deposits and time deposits.

• Click here for Part 2.