Page 510 - Introduction to Business

484 PART 5 Finance

of news stories about the losses, a global run on its deposits took place. Faced with
uncertainty about the bank’s solvency, large depositors around the world immedi-
ately withdrew their funds from the bank. For this reason, government regulators
were prompted to close Continental Illinois and lend money to the bank to enable
it to pay out large sums of cash to cover deposit withdrawals. After the liquidity cri-
sis subsided, regulators divided up the bank and merged it with other healthy insti-
tutions. Continental Illinois demonstrates that public confidence is paramount to
the viability of financial institutions.
One way to reduce the risk of deposit runs and thereby preserve public confi-
dence and protect the safety and soundness of the financial system is for the gov-
deposit insurance A guarantee on ernment to provide deposit insurance. For example, in the United States, each
deposits that protects them from losses deposit account is insured up to $100,000 by the Federal Deposit Insurance Corpo-
due to the failure of a bank or other ration (FDIC), a government agency that protects small depositors. Banks pay the
depository institution
FDIC a premium, or fee, to obtain deposit insurance. By pooling these premiums,
the FDIC raises funds to cover losses by insured banks. If a bank fails, deposit insur-
ance covers the losses of most depositors with small checking and savings
accounts. Typically, a failed bank is merged overnight with a healthy bank by the
FDIC. The next day most customers of the failed bank likely will not even know that
anything has happened. Of course, some observant customers may notice the new
bank name posted on the outside of the bank’s building.
While deposit insurance reduces the likelihood of depositor panics and associ-
moral hazard risk The risk that ated runs on institutions, it introduces what is known as moral hazard risk, the risk
managers of insured institutions will that managers of insured institutions will not manage their risks in a prudent way.
take excessive risk and act imprudently
The reason for this is that, if an institution fails due to excessive risk-taking, the gov-
ernment pays the depositor losses. Knowing that the FDIC rather than the bank
itself pays for losses, managers of banks might act irresponsibly and seek to invest
in high-risk investments in the hope of earning high returns or profits. This “go-for-
broke” approach to management is a dangerous potential side effect of deposit
insurance.
In the event that depositor losses exceed the funds held by the government
insurance agency, then the taxpaying public must pay the losses. Indeed, in the
United States the sudden failure of numerous depository institutions in the early
1980s resulted in taxpayers footing the bill for about $200 billion in losses!
Many experts believe that these losses were in large due to deposit insurance
that encouraged the institutions to take unreasonable risks. Despite the problems
that arise due to moral hazard risk, deposit insurance is crucial to maintaining pub-
lic confidence in banks and thereby contributes to the safety and soundness of
banks.
There are four ways regulation can protect the government and taxpayers from
financial institution losses, including losses due to moral hazard risk. First, insured
institutions must pay deposit insurance premiums to the insurance agency to build
up a reserve to cover losses. As an institution takes more risk in its loans and secu-
rities activities, it must pay higher deposit insurance premiums.
Second, institutions must have adequate equity capital on their balance sheets
to absorb unexpected losses on loans and securities. The 1988 Basle Agreement set
international capital regulations for banks, and similar regulations have been
implemented for other types of financial institutions in many countries. As institu-
tions take more risk, under the Basle Agreement standards, they must increase their
equity capital positions on their balance sheets. Thus, shareholders of institutions
increasingly bear more of the risk of losses as they engage in risky financial market
behaviors. Due to this risk, shareholders will seek to reduce bank risk-taking.

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