Deposit Insurance: Do We Need It and Why?

Depository institutions play a crucial role in an economy. They create assets to finance a portion of government spending, i.e. deficits, and to support private sector expenditures for everything from plant and equipment to consumer durables. They also and simultaneously serve as a repository for savings, providing a positive return as well as payment services to liability holders. However, these two functions create instability in the financial sector, because illiquid assets are financed by liquid liabilities. For this reason, governments throughout the world have established a financial safety net to insure the stability and integrity of the financial system. A central piece of any regulatory structure aimed at ensuring financial stability is the existence of some sort of deposit insurance structure. However, deposit insurance has its own set of problems. It encourages: (i) risktaking by insured institutions; (ii) neglect by depositors; (iii) intervention by regulatory agencies. Each can be explained as a rational response to the existence of government deposit insurance aimed at the lofty goal of financial stability. Depository institutions are encouraged to take risk because the costs of financing risky assets are unrelated to the probability of fault. With the government guarantee, some or all depositors are insured and care little about the assets their institutions hold or their likelihood of failure. Knowing this, regulators are forced to take on a more active role. In essence, they act as a proxy for the market in disciplining risk and encouraging prudence. In the end, the system diverges from its free market counterpart even as it attempts to obtain a socially desirable end. The problems associated with deposit insurance are even greater for Europe as it moves closer to financial integration. With continued movement toward a single currency and a single financial market, the difficulties associated with weighing and minimizing the cost of deposit insurance to achieve its desirable attributes becomes even more difficult. This is because the willingness of different societies to absorb the costs of such a system in order to obtain the benefits of financial stability and the willingness of financial institutions to bear risk will vary. Therefore, in isolation they would have had different types and levels of deposit insurance. However, in a united Europe a convergence will be forced upon them. Where this will all end is still a very open question. But, the potential for discord and financial dislocation is considerable.