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Deposit Insurance Essay

2933 words - 12 pages

University of Strathclyde

Department of Accounting and Finance
M.Sc. Investment and Finance

“Deposit Insurance”
Subject: Financial Markets, Financial Institutions and Banking

Anjul Katyal
Registration No: 20109

Lecturer: Juliane Thamm
Date: 22nd November 2010

This paper shows the existence of deposit insurance in today’s complex economic situation. Deposit insurance schemes are present in most of the countries and are well-established in all developed economies.1 Deposit insurance takes the form of a guarantee to depositors that they will be compensated after the most unlikely event of bank failure. Bank run is not a single model it evolves many ...view middle of the document...

Deposit insurance is increasingly used mechanism by regulatory authority of economies to assure the stability of banks. All most every economy has financial safety structure which includes supervision of banks activities, explicit and implicit deposit insurance and liquidity guidelines.
Deposit insurance is a kind of protection against bank runs that provides ultimate security to investors. In 1994 deposit insurance has become the standard requirement for the creation of single banking market of European Union.2 On the other hand deposit insurance has created some moral hazards for the depositors as well .This scheme has increased risk taking ability of banks all over. Some past examples have clearly shown that some banks often take risk but the amount of risk involved differs from bank to bank which generally contribute to the destruction of market discipline. Different economies are facing distinct problems after financial crisis, in Japan major financial institutions are confined with growing bad debts due to economic bubble. In Europe banking sector is struggling with credit problems. The problem related of Deposit Insurance is even bigger for Europe as they are in move towards single currency and unite financial markets. The reason behind is every society has different risk bearing ability and disagreement in absorbing the cost of system.3
After the deregulation in past decades, over borrowing from international markets has created threat for the banking system of the different economies. Foreign borrowings have lead to the problem of default risk due to inefficient portfolios. In order to explain financial crises Minsky (1977) focused on over investment and over lending problems, and named this phenomenon ‘Euphoria’. Corsetti, Presnti and Roubini (1998) focused on the role of implicit and explicit bailout guarantees on moral hazard problem. Study by McKinnon and Phil (1996)4 signify that over borrowing and bail out guarantees can cause financial crisis in economy. On the other part over lending problem occurs due to flow of asymmetric information and schemes like deposit insurance.
Rationale of Deposit insurance
The scheme of deposit insurance has played a vital role in helping banks to transfer most of their risk to government. Banks are profit making institutions but the amount of risk they face may differ from institution to institution which may lead to different kinds of risks like credit, liquidity and interest rate risk. Sometimes when banks fail to meet the expectations of investors and depositors, it can lead to systemic problems which cannot be handled without government intervention. This problem can further lead to banking crisis. Central banks and regulatory authority should always be prepared to handle the bank distress and failure, to avoid contagion risk and to regain the confidence and interest if investors in financial markets. Most of the economies are saying that deposit insurance is an effective tool to avoid...

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