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Deposit Insurance Works Against Financial Stability

by Jim ONeil on September 22, 2011

in uk banks

For years, academics in money and banking have promoted the idea that deposit insurance is detrimental to the stability of banks. In the 1980s, the U.S. savings and loan crisis illustrated how deposit insurance can fail. Based on this, many experts are less than pleased about deposit insurance developments in the UK in recent years.

Deposit insurance was not instituted in the UK until 1979 and until 2007, it applied to only the first £2,000 of a deposit. When the government introduced 100 percent deposit insurance in September 2007, many financial and banking experts were very surprised. Since then, the blanket protection once provided has been removed. However, the threshold for deposit insurance was increased to £85,000.

Until this threshold is reduced, deposit insurance will inflict damage on financial stability. Previous research reveals that the more detailed and higher the threshold, the more the associated government is tempted to bail out bondholders and other creditors. In general, states will be tempted to bail out banks before the institutions slip into insolvency.

In the latest quarterly bulletin from the Bank of England, there is an article regarding the safeguard of creditors left behind when a financial institution goes bust. Depositors and bondholders rank equally and as such, some matching assets that would have been transferred to a different bank with depositors are instead paid to bondholders. This illustrates the point made by the earlier research.

Deposit insurance was created to decrease financial instability but actually does the opposite. An implicit promise to bail out banks induces the institutions to issue risky loans and leverage themselves. Some experts recommend totally insured deposits but are against them being held in fractional reserve banks. Within each fractional reserve bank, they would like to see a ring-fence of a traditional savings bank that is entirely backed by government bonds.

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