Deposit Insurance and Financial Sector Regulation

By: Bikal Dhungel 

Deposit Insurance simply means, when you deposit a certain amount of money in your bank and the bank goes bankrupt, either an external institution or the government pays back your deposit to you. That means, you are insured and you should not worry even if the bank is having problems. In times of Crisis, it is important. Imagine, when you know that there is a crisis coming and tomorrow you run to the Bank and withdraw all your money and if many thousand people like you do the same, the bank will go bankrupt sooner than later. This will have serious impact in the economy and economic crisis even worsens. Banks should have liquidity. In other words, deposit insurance is a trust. Your trust on your bank that it will not go away.

Banks are integral part of an economy. When banks are having problems, it will shake the economy as a whole depending on how big the bank is. Today, many people do not have trust in their banks. So, they keep money at home, may be inside a pillow or hide it somewhere. This has many drawbacks. The money could either be stolen or loose value in the presence of inflation or the income with interest payment will simply be lost. In the absence of deposit insurance, bank run outs will become frequent. You can see the situation of the US during the Great Depression of 1929. At that time, there was no deposit insurance. So, when the people knew that banks are having problems, they immediately ran to their banks and took their money out. This made the Depression worse. Only after the US introduced deposit insurance in 1930, bank run outs decreased or it became very rare.

Recently, during the crisis of 2007/2008, the German chancellor guaranteed the deposits of people up to Euro 100,000 by the government, which, as a result avoided any problems in the banking sector. Many other countries brought similar policies. This also shows that, even banks might be private, a close supervision by the government is required in order to ensure financial stability. If banks act irresponsibly, for example by keeping the bonus in good times and letting itself rescued by the governments in hard times, can impact the bigger public. So, supervision would hinder the banks to involve in risky activities. However, how the insurance should be managed in another issue of discussion. If the rule first let the bank to bear the cost themselves for example by putting some money aside which was earned in good times to cover the insurance, it will be fair because then the tax payers should not bear the burden alone in difficult times. This will also give incentive to the banks to be careful about their lending, to increase their deposit lending ratio, and to manage the risk properly. As a whole, it will create financial discipline.

The rule of a market economy is, Crisis will definitely come sooner or later. Crisis is a part of market economy. There is no country that never had economic crisis. But if the government and financial sector are better prepared for any such crisis, they can mitigate the consequences together and both of them as well as the society are better off.