[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

to borrow from the Fed protect against illiquidity; they ensure that if depositors
want cash, they can get it.) On occasion a bank will make so many bad loans
that its net worth shrinks to the point at which it can no longer satisfy the capital
requirements.
As a fourth and final backstop, the government introduced the Federal Deposit
Insurance Corporation (FDIC) in 1933. Since then, federal banks and savings and loans
have had to purchase insurance, which guarantees that depositors can get all their
money back, up to $100,000 per account. Because deposits are secured by the federal
government, depositors fearing the collapse of a bank have no need to rush to
withdraw their money. The deposit insurance thus not only protects depositors but
also enormously increases the stability of the banking system. Simply because it
exists, the threat against which it insures is much less likely to occur. It is as if life
insurance somehow prolonged life.
Deposit insurance has an offsetting disadvantage, however: depositors no longer
have any incentive to monitor banks, to make sure that banks are investing their
funds safely. Regardless of what the bank does, their funds are protected. Thus—
to the extent that capital requirements fail to provide banks with appropriate incentives
to make good loans—bank regulators must assume the full responsibility of
ensuring the safety and soundness of banks.
632 ∂ CHAPTER 28 MONEY, THE PRICE LEVEL, AND THE FEDERAL RESERVE