Deposit insurance, moral hazard and undercapitalised banks

By Dr Rod Carr, then RBNZ deputy govenor, in 2001, Banking on Capital Punishment
The arguments against deposit insurance (whether explicit or implicit) are well rehearsed. Depositors and banks take more risk (incur moral hazard). Banks make more risky loans, which crowd out safe loans. Small scale and inefficient banks are protected. Regulatory capture and regulatory forbearance increase the loss given default. Credible deposit insurance may reduce the probability of bank runs as a cause of bank failure and increase the political acceptability of failing insolvent banks, but it does so at the risk of increasing the probability of failure, risks increasing losses given failure and appears to increase fragmentation and inefficiency in the intermediation process. Increased competition may be associated with more participants and industry profitability may be reduced. However, it is more likely that profits are reduced because costs are higher than because fees and margins are lower. A less profitable banking industry may simply reflect a less efficient one.