Bank deposit insurance

Bank deposit insurance (BDI) is part of a financial safety net to ensure against finan- cial instability. In general, BDI was implemented to prevent bank runs as well as to avoid generalized banking crises. BDI operates as a lender-of-last-resort measure to insure 100 per cent bank deposits from losses caused by bank failures. In particular and in practice, BDI can close a bank with less social hardship and less consequential political commotion (Goodhart, 2008). In most cases BDI is government-run, but in some cases BDI can be completely private or can combine a public and a private guarantee.

There exist two types of BDI: statutory and implicit. Statutory coverage occurs when the BDI insures deposit balances up to a pre-established amount (Konstas, 2006). In the United States, for instance, the Federal Deposit Insurance Corporation (FDIC), instituted in 1933, covers deposits up to 250,000 US dollars. In the case of Europe, the Deposit Guarantee Schemes (DGS), established in 1994, covers deposits up to 100,000 euros. An implicit protection occurs when regulators aim to resolve bank failures at no loss to the depositors, or when banks that are "too big to fail" become insolvent and are not allowed to fail.

When financial instability rises, the agency responsible for administering BDI accepts liabilities either by guaranteeing some assets or by infusing cash in exchange for troubled assets; it recapitalizes the failing banks, and provides loans for extended periods to avoid a bank failure and/or financial crises. In the case of the United States, the Treasury main- tains, through the FDIC, a fund to cover the losses of the guaranteed deposits to pay them all, even if the amount surpasses the insured limit (Wray, 2013).

Since the government, through the BDI, assumes all the default risk, banks get to borrow money at the risk-free interest rate. Some may ask whether this creates moral hazard, as low-cost funding provides a competitive advantage, facilitates oligopolistic behaviour, and encourages greater risk-taking. This is the main argument against deposit insurance covering all types of bank deposits, particularly those deposits that may be related to speculation or associated with much risk that may imply a great fiscal cost. Some scholars, such as Rossi (2010), argue that this problem emerges from ignoring the banks' book-entry structure and the types of banks' operations it records, namely income-transferring or income-generating operations. The lack of distinction between these two operations in banks' book-keeping eventually prevents BDI from operating adequately. On the other hand, authors like Minsky (1986 [2008]) and Kregel (2013) argue that moral hazard or risk-taking is difficult to avoid because banks hold two types of deposits: deposits from customers wishing to hold currency and coins, and deposit accounts created by bank loans that involve the purchase of the liabilities of the private sector in exchange for the creation of a deposit account. Both types of deposits are con- flated. Although the second kind of deposits is the one that incurs moral hazard, it is very difficult to identify owing to its nature.

Finally, deposit insurance schemes require the support of a strong central bank in order to meet their commitments (Minsky, 1986 [2008]). Yet the question is, who should bear the cost of rescuing a failing bank when it is responsible for assuming too much risk? The debate is still open.

See also:

Bank deposits; Bank run; Financial crisis; Financial instability; Lender of last resort; Systemically important financial institutions.