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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

A deposit insurance scheme covers small depositors' balances up to a limit if a bank fails. Which side effect is the main economic concern with such a scheme?

The main concern is moral hazard: because insured depositors are protected, they have less reason to monitor their bank, and banks may take greater risks knowing part of the loss falls on the insurer. Deposit insurance actually reduces, not increases, runs by covered depositors.

  1. AMoral hazard, as banks and depositors may take or tolerate more risk because losses are partly borne by othersCorrect
  2. BAdverse selection among borrowers caused by lower interest rates on loans
  3. CA fall in the money multiplier to zero
  4. DCertain bank runs becoming more likely among insured depositors
  5. A rise in the government's tax revenue from banks

Explanation

Insurance reduces depositors' incentive to monitor bank risk, and banks may lend more riskily knowing depositors are protected. This is moral hazard. Insurance in fact makes runs by insured depositors less likely, so the run option is wrong.

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