Demirguc-Kunt and Sobaci (2001:1) states that deposit insurance or deposit guarantee is a complementary element in financial safety net and used by governments to promote stable banking system and protect small investors in events of bank failures. Deposit guarantee can exist either as explicit deposit insurance, which are formal schemes enacted through legislation or through banking law. If there is no such formal schemes, it is assumed that the country has an implicit deposit guarantee system. (Demirguc-Kunt and Sobaci, 2001:482). Similarly, Schich, S. (2009:3) claims that without financial safety net, a simple rumor of financial institutions having solvency or liquidity issues is reason enough for depositors to withdraw their deposits “en masse” and could potentially turn into a self-fulfilling full blown crisis. He further states that deposit guarantee is necessary as it to tend to provide the greater of confidence at the onset of a crisis and reduce the risk of leading to a severe financial crises.
Schich, S. (2008a) notes that economists are skeptical of deposit guarantee and view them as distortions, spawn reckless risk seeking behavior in banks and a moral hazard. He cited four areas that warrants further attention for an effective deposit guarantee scheme: Firstly, the scheme need to have an optimal coverage, as low deposit insurance coverage may not be effective. Secondly, depositors must be educated regarding the extend and limit of explicit deposit guarantees. Thirdly, remove barriers to enable efficient coordination and actions among agencies involve in the delivery of the scheme. Lastly, consider the need for a specific bankruptcy regime for banks.
Nenovsky and Dimitrova, (2003:1) argues that poorly designed deposit insurance and banking system safety nets are predominantly the cause for frequent and severe banking crisis. Providing deposit guarantee is the root cause for moral hazard problems and deem to provide more incentives for banks to take risk. Boyd et. Al (2004:742) further cited underpricing in deposit insurance as an implicit subsidy to the banking system. Greenspan (2003) suggested deposit insurance reform adopts a balanced approach in its trade-off of protecting small depositors and provide short term stability to the system, whilst acting as “implicit” subsidy of deposits growth and inducement for greater risk taking.
Gropp, R. and Vesala, J. (2004) found that with the introduction of explicit deposit insurance in the European Union, risk taking of bank’s are reduced and risk taking at the bigger banks (“too big to fail”) occupying large market share are not affected. Nevertheless, deposit guarantee remains a relevant and potent instrument that is most effective in addressing depositor’s confidence in time of crisis, despite it’s shortfalls and potential cause for moral hazard.
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