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EC2031 Group 3 What Is The Economic Rationale For Government-Backed Deposit Insurance? Should There Be Limits To Such Insurance?

To completely absorb the economic reasoning behind government-backed deposit insurance, we must first acknowledge exactly what we mean by the term. Deposit insurance is commonly known as a method by which bank deposits are protected no matter what happens to the bank or the economy, and so government-backed deposit insurance can be taken as such deposits which are supported by a governing body. One such institution which guarantees depositors money is the Federal Deposit Insurance Corporation, or FDIC, which operates in the Unites States of America and is backed by the US government. Founded in 1934, it upholds the claim that no one has lost any insured money as a result of a bank failure since their inauguration, and currently insures deposits of up to $250,000. There are many reasons why deposit insurance is economically favourable, but the arguably most important one is that its mere existence gives depositors confidence that their money will be safe within the banking system. The result of this is that they are more likely to deposit more funds, enabling the banks to increase their amount of loans. This in turn will boost aggregate demand in the economy, as increased availability of loans will encourage both consumption and investment. The direct rationale for deposit insurance is consumer protection. Depositors, as users of banking products and services, are just as many consumers as are the purchases of other products or services, and the same social & political stresses exist to ensure that they are protected from loss. Moreover, it is more problematic for potential depositors to assess the financial condition of banks than it is for purchases of, say; consumer goods to verify quality before committing themselves. Normally only a limited amount of the information necessary you make an effective up to date assessment of a bank is publicly available and, even then, the general public may have difficulty in interpreting such information. This market imperfection is partly redressed by both banking supervision and deposit insurance. The indirect rationale for deposit insurance, is that it reduces the risk of a systemic crisis. Deposit insurance also highly decreases the probability of a bank run occurring. This happens when depositors experience a sudden loss in confidence in a bank for example, if its portrayed poorly in the media - and so all run to withdraw their deposits. This can have highly negative effects on the bank, and could even cause it to fail if it did not have enough funds in reserve to give back to the depositors. Moreover, if this occurs it is likely that the contagion effect will take hold and confidence will decrease in other banks as well, which could result in nationwide economic difficulties. Deposit insurance helps to prevent this occurrence as it gives the depositors the knowledge that no matter what happens to the bank, their money will be safe and so there is no need to panic and try to withdraw it. It is not easy to generalise about the importance of systemic consideration in the evolution of deposit insurance arrangements in different countries and in different circumstances. For historical reasons, systemic questions have been prominent element in attitudes to deposit insurance in the United States, where insurance was initially conceived as a means of thwarting bank runs. Additionally, deposit insurance helps to offset the existence of asymmetric information. Without it, depositors would have to research which banks are least likely to fail, both when deciding which bank to use initially and then throughout the

EC2031 Group 3

term of their deposit, to ensure that their money is still safe. However, if the bank has deposit insurance, there is no need for this time consuming activity. Regarding whether there should be limits to such insurance, there are arguments for both sides of the spectrum. If there was no limitation, public confidence in banks would be assured to boost, as people would not have to worry about their deposits. However this is unrealistic and very dangerous. Banks would then take on unnecessary risks and the government would possibly have to bail the bank out. Unlimited protection would also build a false impression on banks, as customers would understandably look past how efficient the bank is and concentrate solely on the interest rates they offer. In the long run, this could eventually lead to effective banks being crowded out by those simply offering higher rates of interest. On the other hand, an unlimited value could potentially bring in lots of money from abroad, as foreign banks might choose to deposit in domestic banks which they believe to be safe. Foreign portfolio investment is likely to increase. However, putting a limit on the amount of compensation given, it forces depositors to act more rationally, weighing up the beneficiaries and risks of depositing with less efficient and reliable banks. The question of whether there should be limits to such insurance schemes also raises the quandary of moral hazard. Without deposit insurance, banks would compete for deposits because depositors would prefer safe banks over risky banks to guard their money. With deposit insurance, banks can take excessive risks because depositors do not fear for their deposits safety and thus do not move their money to safer banks. Deposit insurance can create moral hazard by freeing economic agents from the consequences of their actions. From the insurers point of view, it relates to the adverse effects of the deposit insurance on the actions of the depositor. Bank depositors can contribute to this moral hazard as deposit insurance can lead to the depositor not feeling it necessary to assess the bank and the potential credit risk that results from depositing in a particular bank. They therefore may simply be attracted towards the bank with the highest saving rate, bypassing the very important point of how able that bank is to pay its debts which could possibly lead to them losing their money. On a concluding point, from an economical perspective, the existence of government-backed deposit insurance can be thoroughly justified from an economic point of view due to the confidence it instils in depositors, which results in more deposits and a decrease in asymmetric information. Its understood that there should be a limit on the government-backed deposit insurance as it wouldnt be realistic to expect the government to bail out all deposits regardless of size, and there would be substantial moral hazard significances of doing so as banks may take even greater risks if they know that no matter what they are fully backed by the government.