Since 1933, the Federal Deposit Insurance Corporation has been entrusted with maintaining the stability of and public confidence in the US banking system. It does so mainly by insuring deposits, and its existence has enabled consumers and businesses to benefit from lower interest rates and banks to book higher profits than they might otherwise have done. With reserves of more than $45 billion, the FDIC’s ability to fulfill its mission is not in doubt. But events in 2002 convinced the FDIC’s senior leadership that the government agency was beginning to lag behind best practice in financial risk management.

In that year, a difficult economy caused more banks to fail than had done so in any 12-month period since 1994. From 1998 to 2002, the number of problem institutions on the FDIC reserve list—one of many indicators of financial strain in the banking system—rose significantly, while the total assets of these institutions quadrupled, to $39 billion. Yet over the same period, the FDIC’s Bank Insurance Fund reserve ratio (the ratio of the fund balance to total insured deposits) dropped markedly, to 1.27 percent—just above the legal minimum of 1.25 percent. If it fell any lower, the agency would have to...