Question

1. a) Distinguish between implicit and explicit deposit insurance. Give specific examples to illustrate their differences.

b) Explain the “moral hazard” behaviour induced by deposit insurance.

c) Explain two (2) features that can be built into a deposit guarantee scheme to mitigate the moral hazard discussed in part (B).

Answer 1

1.a)

	Implicit deposit Insurance	Explicit deposit Insurance
1.	Implicit deposit insurance system allows the conditions and limits that depositors can expect to be negotiated during the failure process.	Explicit deposit insurance frame out the level and limit the depositor can expect in case of the bank failure.
2.	No rules are set regarding the obligations towards depositors in case of the bank failure.	Specifice rules are set by government towards the depositors in case the banks fail.
3.	Depositors are given preference at the time of liquidation over unsecured creditors.	Depositors are compensated with the limit without special preference.
4.	Example are if banks fails, banks negotiate with the depositor and there is no special arrangement of funding. Repayment is made out of liquidated assets.	Examples is in case the bank fails, a specified method of calculation of repayment is already there with funding arrangement.

b)"Moral hazard" behaviour refers to the incentive for undertaking the risky activities over the low cost insured deposits. As banks believe that their depositors are insured in case of bank's failure, therefore they undertake risky activities such as funding to risky projects to earn a huge profit and insured depositors fail to monitor it.

c) Two features that can be buit into a deposit guarantee scheme to mitigate the moral hazard are:

1. Risk-adjusted premiums which differs in premium and adjust it according to risk undertaken by banks.
2. minimizing the risk of loss through the timely intervention and resolution to troubled institutions.