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

Deposit insurance is introduced to protect small depositors. Which economic problem is most directly made worse by such a scheme if premiums do not reflect bank risk?

The problem is moral hazard. With insured deposits, depositors lose the incentive to monitor bank risk, and banks can fund risky lending at no extra cost if premiums are flat. Risk-based premiums and supervision are used to counter this.

  1. AAdverse selection among borrowers only
  2. BMoral hazard, as banks and depositors have less incentive to monitor riskCorrect
  3. CCost-push inflation in the goods market
  4. DA fall in the money multiplier to zero
  5. Crowding out of government borrowing

Explanation

When deposits are insured, depositors no longer care about the bank's riskiness and banks can take on more risk without paying higher funding costs. This is moral hazard. Risk-based premiums and supervision are used to reduce it.

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