Money that’s been deposited into a bank is generally thought of as safe. This is partly because the FDIC insures bank deposits. But what exactly is FDIC insurance, and how does it work? First, we need to know how banks make money from deposits. Please note that Betterment is not a bank.
When you put money in a deposit account at a bank—let’s say in a checking account or a CD—the money doesn’t just sit there. Instead, the bank turns around and lends it out to other parties who are in need of loans.
The parties that borrow from the bank repay those loans over a longer period of time: think mortgages or lines of credit for businesses. The bank earns money by charging a higher rate of interest on the loans it offers than the interest it pays you on your deposited funds. The bank usually owes you the money that you’ve deposited sooner than the bank’s borrowers owe what they’ve borrowed back to the bank. This is because many deposit accounts that banks offer provide depositors with immediate access to their funds at any time.
This process is called maturity transformation, and it’s at the heart of our modern economic system. It usually works out well for all of the parties involved. You get a place to stash money that you don’t need to spend immediately, other parties get loans to finance productive economic activities, and the bank earns a profit.
Bank Runs and the Great Depression
What happens when the arrangement doesn’t work out so well? Because the bank keeps only a fraction of customers deposits on hand at any given time, there isn’t enough money on hand to allow every single account holder to withdraw their money from the bank at the same time.
If too many people want to access their cash at the same time—known as a “run” on the bank —the bank won’t be able to satisfy every withdrawal request. This can happen during times of economic stress. If there’s a recession or a downturn, and borrowers from the bank have trouble making their regular principal and interest payments to the bank, depositors at the bank may start to get concerned about being able to get their deposits back. The depositors might all try to withdraw their money at the same time.
This is exactly what happened during the Great Depression. Borrowers had trouble making payments back to the bank, depositors became concerned that the bank wouldn’t have their money when they needed it, and the depositors all tried to withdraw their money at the same time. This created a vicious cycle, and many banks failed.
What is deposit insurance?
To restore confidence in the banking system, which had suffered from thousands of bank failures over the preceding few years, Congress created the Federal Deposit Insurance Corporation (“FDIC”) to insure bank deposits. When Congress created the FDIC in 1933, the insurance limit was only $2,500. It has been raised steadily since then, and was last raised during the financial crisis of 2008 to the current limit of $250,000.
The concept of deposit insurance is relatively simple: if a bank fails, the government will step in and pay back up to a certain amount of deposits that otherwise would be lost.
This helps to ensure confidence in the banking system and helps to prevent bank runs. If we can all rest assured knowing that the government will step in to insure our deposits if our banks fail, it’s less likely that we’ll all panic and try to withdraw our money from the bank at the same time. In turn, banks are more likely to survive economic downturns without failing. Deposit insurance prevents the vicious cycle from occurring in the first place.
How Deposit Insurance Works
Deposit insurance isn’t free, but the good news is that there is no direct cost to you as a consumer. Banks themselves pay the premiums to the FDIC in order to receive the insurance coverage. You can easily check to see if your bank participates in the FDIC program by searching your bank’s name on the FDIC website here. FDIC member banks also typically display their membership information prominently on their own websites.
The table below lists the most common types of banking products and indicates whether or not they are typically covered by deposit insurance through the FDIC—as long as the institution is a member firm.
Source: FDIC and SIPC
Note that investment products generally aren’t covered by FDIC insurance. Instead, they are protected by SIPC up to a certain limit, which covers losses due to failures of member broker-dealers in certain circumstances.
What are the limits?
There are limits to the FDIC insurance coverage. The FDIC insures only up to $250,000 of deposits for:
a) a single depositor,
b) at a single banking institution,
c) in each account ownership category.
Examples of a single depositor include an individual, a business held as a sole proprietorship, or an estate.
Examples of ownership categories include individual accounts, joint accounts, retirement accounts, and trusts. You could receive more than $250,000 of FDIC insurance at a single bank, depending on how your deposits are spread among multiple ownership categories.
In the example below, a depositor has an individual checking account holding $100,000, and a joint checking account at the same bank holding $200,000. Even though the total between the two accounts is $300,000, which is over the standard limit of $250,000, the full balance would be covered because it’s split across two types of account ownership categories.
You could also receive more than $250,000 of FDIC insurance if your deposits are spread across multiple banks, as long as the banks are truly separate and not just continued branches of one single bank.
In the example below, Bank A holds $250,000, Bank B holds $250,000, and Bank C holds $50,000—all in individual accounts. Although the total across all three banks is $550,000—well beyond the standard limit of $250,000 for the individual account ownership category at a single bank—each separate balance is still fully covered due to the fact that the funds are held at three separate banks.
What if my bank fails?
The FDIC and state banking regulators monitor banks on an ongoing basis to ensure that they are financially able to meet their obligations. If an FDIC member bank is determined to be unable to meet its obligations because it is insolvent, the FDIC will close the bank and put it into a status known as receivership. In receivership, the FDIC will settle the bank’s debts and sell the bank’s assets—typically to another bank.
In addition to overseeing the receivership, the FDIC also will pay out the insurance to depositors of a failed bank. If your bank closes, the FDIC will reach out to each customer by sending a letter to the address it has on file. You might also hear of your bank’s failure on the news, or on notices either at the bank’s physical location or on their website—especially if you use an online bank.
After your bank closes, the FDIC aims to pay your deposits back to you within 2 business days. If you had more money deposited than what is covered by current FDIC limits, you could then file a claim against the bank’s estate for any non-insured funds that were lost. After the bank’s assets are liquidated and sold as part of the receivership process, you may be entitled to a portion of those assets, if anything is left over.
The FDIC was created to restore faith in the banking system. We hope that our explanation of how deposit insurance works helps you to feel confident as you manage your cash.