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The riskier something is, the more interest/coupon would be demanded by the lender. In the case of choosing where to put my savings, wouldn't the existence of FDIC incentivize searching for the bank that pays the highest interest on my savings?

FDIC guarantees that my savings will remain intact (as long as it is below some amount) regardless of what happens to the risky savings bank. Wouldn't it incentivize me to disregard the risky nature of the bank? How does FDIC remedy this conflict of incentives?

Flux
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The rate paid on savings accounts does not indicate that a bank is risky or not. There are lots of regulations in place for FDIC insured banks to comply with as well. There is a whole lot to read on this depending on how bored you are, see the FDIC's website below.

https://www.fdic.gov/regulations/

user1723699
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The FDIC's guarantee does incentivize putting your money in the bank that gives the best interest. In fact, banks do compete on interest rates and people do switch to get better interest rates. The reasons that everybody doesn't switch to the bank with the best interest rate are probably varied but likely include

  • Banks compete on more than just interest rates. location, ATM fees, overdraft protection, location, etc. These other factors may be more important than the interest rate to some borrowers.

  • Ignorance, complacency and/or inertia. People may not know there are better offers or may not care. The difference in terms of returns may be so small that going through the hassle of switching banks might not be worth it to this person (imagine switching credit cards, autopay, direct deposit, etc. for maybe $20 more a year). People may be happy with the service they're getting and not think it worth the extra effort.

If your question is why banks just don't keep raising the offered interest rate on deposits to bizarre levels to attract depositors (after all, if they go bankrupt, the FDIC will bail them out)… well, the bank's priority is to make money, so they still have a strong incentive to balance paying more interest with making more profit. It makes no sense to offer more in interest than they can collect in interest on the loans they give out, minus overhead.

Patrick87
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No bank wants to be considered "risky" at all. Savings rates are intended to be essentially "risk free"; they should not include any component of credit risk.

Banks can have higher savings rates for several reasons, such as being willing to take less profit in exchange for more deposits (e.g. a higher rate if you deposit, say, $25,000) or as a loss-leader for other services (loans, etc.).

D Stanley
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How does FDIC remedy this conflict of incentives?

The Federal Reserve regulates banks, checking them for solvency. The FDIC relies on that regulation.

https://www.federalreserve.gov/publications/2020-ar-supervision-and-regulation.htm

Supervisory and Regulatory Initiatives

The Federal Reserve's supervision activities include examinations and inspections to ensure that financial institutions operate in a safe and sound manner and comply with laws and regulations. These include an assessment of a financial institution's risk-management systems, financial conditions, and compliance. The Federal Reserve tailors its supervisory approach based on the size and complexity of firms—supervisory oversight ranges from a continuous supervisory presence with dedicated teams of examiners for large firms to regular point-in-time and targeted periodic examinations for small, noncomplex firms.

RonJohn
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What most savers forget or don't realize is that deposit insurance schemes do not have the money to pay for failure of a large bank. Large banks are simply too large to fail, and if one bank fails, it can cause a chain reaction leading to all banks failing.

If the bank is very small, the deposit insurance schemes could have money to pay all account holders.

So, generally it is recommended to stick with accounts in reputable banks from which you can withdraw the money at a moment's notice.

If saving significant amounts of money, in a positive interest rate environment, it might make sense to invest into a money market fund. Such a money market fund invests into certificates of deposit and fixed-term accounts having maturity of at most a year. There is a large portfolio of various remaining maturities, in various different banks. If one bank fails, it could theoretically wipe away part of your money (perhaps 10%?), but only part, and it is likely that most major banks will be saved from failing by the government, as the deposit insurance schemes do not have enough funding.

Avoid funds that have variable-rate papers seemingly less than a year (duration), but with long maturity actually. Avoid funds that have commercial papers.

In theory, deposit insurance could give incentives to take more risk, but there will be delays in getting the money from the deposit insurance. The risk-free part of the portfolio (money market, government bonds) is not the place to take risk! Almost always, if the amount of return is not good enough, it makes sense to simply invest more into stocks and less into money market and government bonds. So, only the foolish are incentivized to take more risk in the money market + bond parts of the portfolio by the deposit insurance schemes.

juhist
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