Trust Co. The FDIC adopted an explicit policy of protecting all deposits in Continental and, subsequently, a number of other banks it determined were too big to fail. By 1985, deposit protection was virtually 100 percent in all banks, regardless of size. The Treasury's February report to Congress on banking reform states that since 1985 over 99 percent of uninsured deposits have been protected in failed banks. With virtually full protection of all deposits providing as much stability to the U.S. banking system as one could hope for, there was no longer a need for the traditional central bank function of lender of last resort. However, the price for that stability has been the erosion of market discipline of depositors and, in turn, the banks.
Market discipline is needed to contain the moral hazard in deposit insurance.
Moral hazard is an inherent characteristic of insurance that erodes, if not destroys, market discipline by reducing the insured's attention to the risks insured against. In the case of deposit insurance, full protection has made depositors indifferent to the risks undertaken by the banks that hold their deposits. Unfortunately, the trade- off for this market discipline may by added instability to the banking system. However, still substantial deposit insurance, coupled with the Fed's effective use of its lender of last resort power, should provide adequate stability. Although the act imposes limitations on Fed lending, the Fed is left with sufficient power to perform the lender of last resort role contemplated when it was created.