Question

Econ364 Money & Banking

Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain your answer.

Answer 1

It's not a good idea. Eliminating or limiting the amount of insurance on deposits would help to reduce the moral hazard of banks taking excessive risk. This will raise the risk of bank failures and panic

In response to the Great Depression, the first deposit insurance policy was developed in America. The object was to prevent ever again happening the bank runs that led to the depression. Deposit insurance is based on the idea that if depositors realize that as a result of bank failure the government will refund their deposits, they will not bother trying to withdraw their deposits even if they find out that the bank is insolvent.

This is intended to prevent bank runs that are suspected to be insolvent and financially demanding. Therefore, those insolvent banks will not have to conduct a fire sale of their capital to raise money quickly. Fire sales are undesirable because they can lead to a fall in asset prices, which can also lead to other (including banks) holding similar assets becoming insolvency. Left unchecked, it may result in debt deflation.