Essentials of Money, Banking and Financial Institutions by Andoh Samuel K.; Abugri Benjamin A.; Kuforiji John Oluseyi

Author:Andoh , Samuel K.; Abugri, Benjamin A.; Kuforiji, John Oluseyi
Language: eng
Format: epub
Publisher: Lexington Books

Deposit Insurance

To create and maintain public confidence in the banking sector, and to prevent panics, a number of countries have instituted what is commonly referred to as deposit insurance. The purpose of a deposit insurance scheme is to assure depositors that, in the event of a bank failure, the insurance will pay for their deposits up to predetermined levels. This assurance gives depositors confidence in their banks and thus discourages them from running to their banks to withdraw deposits, which itself contributes to the panic and collapse. To accomplish this, banks are encouraged or forced to participate in the deposit insurance schemes by paying insurance premiums to the deposit insurance company. Banks which insure the deposits of their customers display information about their deposit insured status as a way of boosting the confidence of customers and would-be depositors.

In Nigeria, following the failure of twenty-one of the twenty-five indigenous banks in the 1950s, recommendations were made for the establishment of national deposits insurance. It was not until 1989, when banks in Nigeria began to increase rapidly, that the Nigeria Deposit Insurance Corporation (NDIC) was established. In Africa, as of 2012, only nine out of the fifty-four countries had deposit insurance: Nigeria, Tanzania, Uganda, Sudan, Zimbabwe, Algeria, Kenya, Morocco and Lesotho. The United States has had one since 1933 and now insures deposits of up to US$250,000.00.

The absence of explicit deposit insurance does not mean that it does not exist. In many countries, there is the implied assumption that, if a bank fails, the government will step in to rescue deposit holders. In recent times, this concept has been elevated to the status of a truism, in particular when it comes to big banks. It is expressed in the doctrine of too-big-to fail. An institution whose failure will bring calamity to a large segment of the economy is often rescued by the government.

Critics often argue that the main goal of deposit insurance may be defeated because banks that are insured under the scheme, may in fact take on more risky activities because of the insurance policy. Also, they argue, depositors will now not do their due diligence on banks before selecting them. The discipline of the market will be lacking in such cases. Such an outcome defeats the intended purpose of the scheme, that is, to reduce the risk exposure of depositors to risks. Taking on more risk because of protection by an insurance policy is a classic case of moral hazard. To discourage insured banks from taking on higher risk, many deposit insurance schemes require a risk-adjusted insurance premium from the banks. A risk-adjusted insurance premium means that banks taking on high risky activities are required to pay higher deposit insurance. In the absence of risk-adjusted premiums, bank regulators may opt to restrict the types of activities that banks take on. Such restrictions may be considered as implicit premiums to the banks intending to undertake the highly risky activities. It is the too-big-to-fail doctrine which has now spawned what is known as the Volcker rule.

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