Financial systems and development

Box 2.5 Deposit insurance
Most high-income and a few developing countries and should never be insured. This contrasts with the
have established deposit insurance schemes. Deposit savings and loan associations in the United States,
insurance guarantees the nominal value and liquidity which, in addition to having insureu deposits, do most
of deposits up to a certain size. The insurer is an insti- of their short-term borrowing from the Federal Home
- tution, generally government-owned, established for Loan Bank System, which lends according to less dethat
purpose, and funded with premiums paid by the manding standards (see Box 5.4 in Chapter 5). An inesinstitutions
whose deposits are insured. Deposit insur- capable fact of deposit insurance is that it places greater
ance can help to establish confidence in the safety of responsibility on government to see to it that insured
saving with banks (or other covered institutions) in institutions behave prudently.
countries with limited banking habits. The principal With or without insurance, depositors would be fully
targets of deposit insurance are small, unsophisticated protected if banks were closed and liquidated the modepositors
who are least able to assess the soundness ment their capital fell to zero. This is not a practical
of a particular depository. By assuring depositors that possibility: the condition of a bank cannot be known to
their money is safe even if the depository is not, de- inspectors minute by minute and, because liquidation
* posit insurance supplements the central bank's lender- takes time, asset values can decline before liquidation
of-last-resort role in forestalling bank runs. can be completed. However, up-to-date market ac-
Like all insurance, deposit insurance suffers from the counting, frequent inspection, and swift action by inrisk
of moral hazard. Because insured depositors no spectors to close insolvent banks are clearly important
longer need to be concerned about the quality of their in minimizing losses. In some countries the laws estabdepository's
assets, market regulation of bank behav- lishing deposit insurance provide the mechanisms for
lor is reduced. A considerable degree of market regula- exactly such steps. Furthermore, the enhanced supertion
can be retained if deposit insurance coverage is visory capability that sometimes accompanies the eslimited
to relatively small deposits. The interbank de- tablishment of deposit insurance can and should be
posit market, which has become an important source of used to spot problems in bank management and in
short-term liquidity for all advanced banking systems, banks' portfolios well before insolvency occurs and to
can impose a significant measure of discipline on banks compel banks to take corrective action.
ing the allocation of resources, it too affects the ple, of monitoring and control of bank managers
structure and efficiency of the financial sector. For by stockholders and depositors. Innovative finanexample,
many governments have honored the lia- cial entrepreneurs have often been able to evade
bilities of insolvent financial institutions even the rules; those intent on deceiving bank examwhen
there was no formal insurance. Government iners have often succeeded in hiding losses for
guarantees and lender-of-last-resort facilities, some time.
however, changed the behavior of both depositors Many countries have therefore moved in recent
and bankers. Depositors and other buyers of bank years to strengthen the role of the private sector in
liabilities that were either explicitly or implicitly in- monitoring and controlling financial enterprises.
sured no longer had to monitor banks to protect Some have set higher capital requirements for fithe
value of their deposits. Bankers no longer had nancial institutions. This ensures that the owners
to worry about runs, so they could make riskier have an adequate stake in the efficiency with
loans. Governments therefore had to regulate and which depositors' resources are used. Similarly,
supervise the system.
stringent audit and reporting requirements make
Deposit insurance, coupled with regulation and an institution's financial condition visible to depossupervision,
has reduced the problem of bank runs itors and investors. And yet some governments
but has been less successful in preventing fraud have also covered losses that in the past would
and excessive risk taking by banks, as the present have been borne by market participants. This runs
widespread insolvency among the financial institu- counter to the principle of allowing market signals
tions of the developing countries makes clear (see a greater role in supervising the system.
Chapter 5). And high-income countries have not The task of balancing efficiency, which requires
been exempt (see Box 5.4). It is often argued that freedom to act, and stability, which evidently regovernment
supervision is not an efficient substi- quires a degree of government regulation, is extute
for market supervision-in the form, for exam- tremely difficult. Some theorists argue for an un-
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