Deposit insurance : an analysis and legislative proposals

Abstract

This thesis focuses upon the role and purpose of deposit insurance schemes (DIS). The introduction of deposit insurance as part of the domestic financial safety net is expected of well regulated financial environments. Such systems are designed to reduce the risk that depositors will suffer a loss in case of a bank failure. The beneficiaries of such systems are the small and unsophisticated depositors who do not have the means with which to monitor the performance of banks and to decide which is the safest. Deposit insurance is deemed to increase depositor confidence in credit institutions thereby enhancing the stability of the banking system. The sense of depositor confidence is very important since its deterioration can lead to bank runs that can prejudice the stability of the economy. Thus, a well-designed Scheme reduces the probability that depositors will panic and withdraw their funds when they perceive that their bank is experiencing financial difficulties. The thesis discerns the negative effects which may be generated by deposit insurance. The fact that depositors are protected leaves them little incentive to monitor the performance of their bank. On their part, the credit institutions tend to pursue riskier operations, by, for example, offering higher interest rates, in order to attract a higher return. The banks can act in this manner since their depositors are protected by a relatively low cost protection scheme. This gives rise to moral hazard which is inherent to all kinds of insurance. Effective steps must be taken to curtail moral hazard because it may destabilise the financial system. However, policymakers cannot expect to eliminate moral hazard - it can only be controlled by adopting measures such as strong supervisory and regulatory regimes. In conclusion, it must be pointed out that there is no single combination of elements that suits every country. The policymakers must determine the most suitable system which reflects the current local conditions.