Is Deposit Insurance Really the Solution to Depositors’ Worries?

Deposit insurance is an attractive tool for politicians, especially in crises such as this one. Announcing (unlimited) coverage of deposits in the banking system can prevent depositors from bank runs. And as long as the authorities do not have to make good on their promise, it is also a cheap tool. By now, however, most economists are well aware of the moral hazard effects of generous deposit insurance, a product of reduced market discipline. The result? Aggressive and imprudent risk taking. But considering recent events in Russia, one should be careful about believing blindly in the confidence-creating effect of deposit insurance either.

Some months ago, a small Russian bank called Capital Credit simply refused routine withdrawals by their customers, thus clearly signaling its illiquidity (which normally comes after insolvency!). But the Central Bank of Russia (which is also responsible for bank supervision) did not take any action for several weeks despite heavy protests by depositors. Only when depositors threatened to demonstrate in front of the Central Bank did bank supervisors finally withdrew Capital Credit’s license, thus allowing depositors to start the process of recovering at least part of their savings from the deposit insurance.

The result: despite an explicit deposit insurance scheme and despite the government’s assurance that all deposits would be secure, a loss of trust and confidence in the banking system occurred. As long as bank supervisors are not strong enough to intervene into failing banks, deposit insurance schemes cannot help conserve or restore confidence in the banking system.