In the absence of government intervention, a bank collapse means that a depositor would have to wait to get their deposit funds until the bank is liquidated and its assets turned into cash, and at that time, they would be paid only a fraction of the value of their deposits. If bank managers were taking on too much risk, depositors would be reluctant to put money in the bank. Also a lack of information about the quality of a bank's assets available to a depositor can lead to runs on banks, which can have serious and harmful consequences for the economy.
A government safety net for depositors can short-circuit runs on banks, and by providing protection for the depositor, it can overcome reluctance to put funds in the banking system. With fully insured deposits, depositors do not need to run to the bank to make withdrawals - even if they are worried about the bank's health because their deposits are covered no matter what.
Although a government safety net can be very successful in protecting depositors and preventing bank panics, it is a mixed blessing. With a safety net depositors know that they will not lose out if a bank fails, but at the same time they do not impose market discipline on banks by withdrawing deposits when they suspect that the bank is taking on too much risk. Consequently, banks with a safety net have an incentive to take on greater risks than they otherwise would.
The people who are most likely to engage in activities that may cause a bank to crash are those who most want to take advantage of the insurance. Because depositors who are protected by a Deposit Protection Fund have little reason to impose discipline on the bank, risk-loving entrepreneurs might find the banking industry a particularly attractive one to enter - they know that they will be able to engage in highly risky activities. It is for this reason that the Ministry of Finance refused to allow non-banking entities (like the firm Drukos and BMG Invest) to take stakes in banks soon to be privatised.
Once creditors know that a bank is too big to fail, they have no incentive to monitor the bank and pull out their funds when it takes on too much risk. No matter what the bank does, uninsured creditors will also not suffer any losses. The effect of the 'too big to fail' policy is that big banks might take on even greater risks, thereby making bank failures even more likely. The government came to realise this when the mid-sized bank Devín Banka ran into liquidity problems and the Deposit Protection Fund was emptied.
All governments provide some form of safety net for the banking system. On the other hand, though, they need to take steps to limit banks running excessive risks. The effect of moral hazard [the taking of greater risks in the knowledge of insurance - ed note.] coming from government safety nets can be eliminated if premiums for insurance are priced appropriately to reflect the amount of risk taken by a bank. For instance, deposit insurance premiums in the United States are based on a bank's classification into one of three capital adequacy groups. The higher the capital adequacy, the lower its insurance premium.
The amendment to the Banking Act due to pass through parliament by the end of this year consists mainly of the implementation of prudential criteria which should restrict banks taking on excessive risk. It is expected that a further amendment to the Deposit Protection Fund Act will bring about a cut in the coverage of deposits to 90%.
Juraj Kotian is a research analyst at state bank Slovenská Sporiteľňa. Comments and questions can be sent to him at:firstname.lastname@example.org
20. Nov 2000 at 0:00 | Juraj Kotian