Does Government Deposit Insurance Enhance a Country's Economic Stability?

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David J. Simmons
FIN 590: Global History of Finance
Assessment #4
“Does Government Deposit Insurance Enhance a Country’s Economic Stability?” Dr. Mary H. Kelly
December 9, 2012

Economic crises have been common throughout the last century and have had catastrophic effects on financial markets throughout the entire world. The “Great Depression” of 1929 and the “Savings and Loan Crisis” of the 1980s are examples of monumental financial market failures in history. Greed, corruption, overly aggressive investing, and an inability to forecast changes in the global market have all been catalysts to market failures throughout the world. Systematic financial collapses pose significant challenges to governments and private entities that are employed, empowered, and entrusted to protect the financial interests of the people. As the walls of financial systems come crashing down, it is normally the average citizen who is unprotected and suffers during the aftermath. In an effort to protect the investments of citizens, mitigate risk, and induce economic growth, an early form of deposit insurance was created in New York State in 1829 (FDIC, 1998). Several other states also attempted to institute deposit insurance but they never really hit the mark. It wasn’t until the Great Depression that a truly comprehensive deposit insurance program was created. However, was the implementation of deposit insurance the “end all, be all” answer to stabilizing a country’s economy? In order to answer that question we’ll first define deposit insurance and identify the different methods of implementation. Next, we must analyze both the advantages and disadvantages of utilizing a deposit insurance program. Thirdly, we must analyze how external factors can impact the effectiveness of deposit insurance programs and what controls can be utilized to mitigate these effects. Finally, after analyzing all aspects of deposit insurance, we’ll be able to decide if deposit insurance actually enhances the stability of a country’s economy or not.

Similar to how automobile insurance guarantees to pay for repairs, theft, or loss due to natural disasters, deposit insurance also guarantees to repay funds that are lost when a bank becomes insolvent. Deposit insurance can be funded by the government, privately, or a combination of the two. In 1933 the Federal Deposit Insurance Corporation was created in order to provide deposit insurance to banks. The FDIC thoroughly vetted all banks to assess their level of solvency prior to insuring their deposits (FDIC, 1998). After being approved for insurance, the banks were then required to pay annual premiums towards the insurance fund. Deposit insurance can be implemented explicitly or implicitly. Explicit implementation means that there is a formal, clearly defined system of deposit insurance. Implicit implementation means that there is no formal agreement and the state or government entity can provide assistance as it deems necessary. Deposit insurance can be implemented on a compulsory or voluntary basis based on the regulations of the government. Coverage limits and annual premiums must be considered and are directly correlated with the level of risk associated with the insured banks. Demirguc-Kunt and Kane has noted that countries such as Columbia, Ecuador, Indonesia, and Japan provide one hundred percent depositor insurance while countries such as Austria, Belgium, Denmark, Finland, and Germany insure deposits based on the per capita gross domestic product amount. There are additional implications when determining how large or small to set liquid reserves in the event of a crisis. Fund managers must decide whether or not to insure foreign currency deposits as well as interbank deposits. Finally, institutions must decide whether public, private, or a combination of both public and private management will be utilized to manage insurance funds (Demirguc-Kunt and Kane, 2002). The characteristics, categories, and forms of...
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