Market Discipline - Deposit Safety Nets

Deposit Safety Nets

Deposit insurance in the U.S. was instituted in 1934 to restore depositor trust into the financial markets following the devastation of the Great Depression. It worked quite well for many decades in terms of preventing a major bank run and systemic risk.

In the last couple of decades there has been increased criticism about its benefits. Concerning market discipline, one can easily say that mispriced deposit insurance distorts the incentives of depositors to monitor bank risk taking activities. For example, 100% of deposits are under government guarantee (up to $100,000) in the U.S. compared to only 70% in England. Obviously, the depositors in England, knowing that they will lose money when the bank they are investing in fails, will be more cautious than U.S. depositors and will monitor bank activities with vigilance.

The question that challenges policymakers is really what an optimal deposit insurance scheme might be. Moreover "How to design and implement it?"

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