Deposit Insurance

Purpose of Deposit Insurance

Protects small depositors from loss if a bank fails, promoting confidence in the banking system and preventing bank runs

Deposit Contracts & Withdrawal Risk

Deposits are first come, first-served, which can trigger bank runs. If depositors fear insolvency, they rush to withdraw - leaving the last ones at risk of losing everything

Types of Deposits

Demand Deposits - Withdraw anytime, no notice required

Notice Deposits - Require advance notice to withdraw

Term Deposits - Locked in for a fixed term; penalized for early withdrawal

Liquidity Risk

Liquidity Risk: The bank has enough assets, but can’t convert them to cash fast enough to meet withdrawals.

Liquidity problems can cause insolvency if forced to sell assets at a loss

Insolvency Risk

The bank’s liabilities exceeds its assets - true bankruptcy

How Deposit Insurance Prevents Bank Runs

By guaranteeing deposits up to a limit, deposit insurance removes the incentive to withdraw during panic, as depositors know their money is safe

Benefits of Deposit Insurance

Protects small savers

maintains public confidence

Prevents contagion across banks

Supports financial system stability

Problems with Deposit Insurance: Moral Hazard

With insurance, banks may take more risks, knowing depositors are protected. So deposit insurance weakens market discipline as depositiros no longer monitor bank risk

Stockholder Discipline (Controlling Risk-Taking Behavior)

Aims to force bank’s owners (shareholders) to behave responsibly

Capital Requirments for banks to hold minimum cushion amount using their own funds, so they take a hit first

Risk Based Insurance Premiums made risker banks pay higher deposit insurance fees

Early Closure Rules forced weak banks to shut down before they burn though everything

Depositor Discipline (Controlling Risk-Taking Behavior)

Means making depositors care about whih bank they use, and to avoid risky ones

Deposit insurance cover $100,000 not anything over, so if you have more than that you will monitor bank health

But too-big-to-fail banks will be bailed out so everyone is protected anyways so large depositors stop monitoring

Regulatory Discipline (Controlling Risk-Taking Behavior)

This is when government regulators keep banks in line

They do on-site examinations, stress tests and regular reviews to make sure everything is up to code

They enforce Prompt Correct Action rules which means regulators will step in when capital levels drop, restricting bank activities (restrict dividend, force recapitaliztion)

Risk-Based Premium System

Banks pay premiums based on their risk profile. Safer banks pay less, and riskier ones pay more - aligning incentives and limiting moral hazard

Payoff Method (Handing Bank Failure)

Insured deposits are paid out by CDIC/FDIC and the bank’s assets are liquidated

Purchase & Assumption (Handing Bank Failure)

A healthy bank purchases the failing bank and assumes its deposits and some assets

Open Assistance (Handing Bank Failure)

CDIC injects capital or loans to prevent failure, however this only happens for large banks which pose a systemic risk if they failed

Insured Depositor Transfer (Handing Bank Failure)

Transfers only insured deposits to a healthy bank; uninsured depositors take a loss

Too-Big-To-Fail (TBTF) Policy

Some large banks are considered too interconnected to the financial system to fail. Governments will bail these banks out to avoid a system wide collapse, even if deposits exceed insurance limits

FDIC Improvement Act (FDICIA)

Law aimed to reducing risk and TBTF issues,

Introduced Prompt Corrective Action Rules

required risk based premiums to be paid by banks

Created rules for Systemic Risk Exceptions where Treasury and FED had to both agree before a bail out occured