Capital Rules of the FDIC
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The FDIC provides insurance. If the bank fails, the deposits are insured so people don’t lose money. The thing is, having insurance may cause some people to be more risky. If you have car insurance, you may be more likely to text and drive knowing that an accident won’t bankrupt you (for example). Economists call this phenomenon moral hazard.
Some ways to get around moral hazard are risk sharing (like insurance deductibles), or other requirements (like making buildings have sprinkler systems).
For banks, knowing that they are insured may encourage some to gamble on high-risk / high-reward investments. To prevent this, the FDIC makes investors in the bank (stock holders and bond holders) take losses before depositors do. The money investors have put into the bank is called investor capital. The FDIC requires a set amount of investor capital for each dollar of deposits (hence the term Capital Requirements). For example, a bank with $900 million in deposits may be required to hold $100 million in investor capital. This way, if the bank loses up to $100 million, the insurance does not have to pay out.
The FDIC takes this one step further by requiring different amounts of investor capital depending on how risky the bank is. If the bank only invests in U.S. government bonds, they only have to carry a little bit of investor capital. If they only invest in crypto loans, they may have to carry equal amounts of capital and deposits ($900M in capital for $900M in deposits, from our example earlier).
Banks report their financials to the FDIC regularly, and the FDIC has a team of examiners who double check to make sure that banks are being honest. Of course, sometimes banks still fail, but that doesn’t mean the system is bad. That’s exactly what the insurance is for, the requirements are there to make sure the insurance system is not overwhelmed.
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