How Safe Is Your Money? Understanding Deposit Insurance

Recently, many financial institutions, including SOFIPOs and banks, have been offering very attractive rates on daily deposits to capture market share. This has led to questions about the sustainability of these rates and the safety of deposits, especially as we face the prospect of economic deceleration and the troubles at financial company CAME. The fundamental advice is straightforward: Diversify your deposits and utilize deposit insurance to its fullest extent. Let’s delve deeper into this topic.

Nearly a century ago, the Great Depression saw widespread bank failures, eroding public trust in the financial system. People resorted to hoarding cash, which disrupted the flow of loans to businesses and kneecapped economic activity — a vicious cycle. To rebuild trust and reverse this situation, the Federal Deposit Insurance Corporation (FDIC) was established in the United States in 1933. The FDIC operates by insuring deposits up to a certain limit. Banks pay premiums for this insurance, which is then used to reimburse depositors in case of bank failures.

In Mexico, the Instituto para la Protección del Ahorro Bancario (IPAB) serves a similar purpose, insuring deposits up to 400,000 UDIs (investment units), or approximately MX$3 million (US$154,000), per depositor per bank. For example, if you have MX$7 million, it would be prudent to spread it across three different banks to ensure full coverage. For SOFIPOs, the equivalent body is PROSOFIPO, which insures deposits up to 25,000 UDIs, or about MX$210,000. If you have MX$1 million in SOFIPO deposits, it’s best to divide it among five different institutions.

Beyond insurance, it’s wise to avoid depositing money in institutions that seem likely to face trouble. Even with insurance, dealing with a bank failure can be a significant hassle. This is one reason why large, seemingly stable institutions tend to attract more deposits, sometimes becoming “systemic” and, in extreme cases, even being considered “too big to fail,” meaning their failure could have severe repercussions for the entire financial system and the wider economy.

To understand IPAB and PROSOFIPO fully, it's helpful to look back at Mexico’s banking history. In the 1980s, banks were nationalized, but in the 1990s, they were largely privatized. This privatization process had severe issues, with some buyers lacking banking experience and even financing acquisitions with loans from the very banks they were buying.

During the 1994-1995 “Tequila Crisis,” the peso devalued and interest rates rose. It didn’t help matters that banks had engaged in risky lending and even fraud. To prevent a financial collapse, the government created the Fondo Bancario de Protección al Ahorro (FOBAPROA). This bailout cost over US$100 billion, a significant burden on taxpayers that is only expected to be fully repaid by 2050! Some bank shareholders walked away with their fortunes, while many ordinary citizens lost everything. This led to social movements like “El Barzón,” which protested the human cost of these policies. 

In 1999, banking insurance was reformed, creating IPAB, and foreign investment in banks was allowed. Subsequently, institutions like Santander, HSBC, and Citigroup acquired significant holdings in Mexico. Nearly a decade later, in 2008, a global banking crisis erupted, leading to the US government’s Troubled Asset Relief Program (TARP).

Recent debates highlight differing views on economic policy and government intervention in financial crises. One side emphasizes holding elites accountable, while the other stresses the complexity of decisions made during such crises. Whatever your views, preventing future crises is something we can all agree on. Here are some ideas:

1. Strong Regulatory Oversight: Enhanced financial regulations and monitoring to proactively identify and mitigate risks.

2. Supervisory Technology (suptech): Using technology like AI and APIs to provide real-time data to regulators for better oversight.

3. Rule of Law: Ensuring financial institutions and executives are held accountable through robust legal frameworks.

4. Competition and Financial Inclusion: Fostering a more diverse financial system to reduce reliance on a few large institutions and distribute risk. Some suggest 100% deposit insurance would help erode “too big to fail” positions.

5. Clear Bailout Protocols: Establishing transparent guidelines for government intervention, focusing on protecting deposits, not shareholders and/or negligent management.

If you’d like to be part of the solution, check out our job postings on www.revolut.com/careers