What Is the Economic Rationale for Government-Backed Deposit Insurance?

647 Words Dec 3rd, 2011 3 Pages
What is the economic rationale for government-backed deposit insurance?

Case Study: The Federal Deposit Insurance Corporation (FDIC)
The most important government agency is The Federal Deposit Insurance Corporation, whereby each depositor is insured to at least $250,000 per insured bank in the case that a financial intermediary should fail. This protects people’s deposits so that they do not face a great financial loss.

* When a bank fails it means they are unable to meet their obligations to pay its depositors and other creditors. Therefore deposit insurance was introduced in 1934 in order to protect those, for when a financial intermediary failed. * In the first 10 months of 1930, a total of 744 US banks failed. In
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Instead the Federal Deposit Insurance Corporation will put them under new management.
Should there be any limits to such insurance?
With recessions happening all over the world and the euro crisis, people are no longer confident in their bank. They prefer to hold onto their money instead of saving it in a bank account. By having the safety net of insurance, people will feel they can put their money in a safe place within the bank.
When you have extremely large financial institutions or markets, their failure has the potential to bring down the entire financial system. In cases like this we need the government to provide the support. Putting a limit on a valuable corporation that has recently failed can cause a loss of millions of pounds/euros/dollars in an economy.
On the other hand having a limit on the insurance can mean that when the Federal Deposit Insurance Corporation raise the limit then depositors will put more money into their bank accounts. So when the government increase the limit, suddenly the banks will see an inflow of relatively cheap funds. This can suggest the banks are in a better situation.
The main reason for having limits is that if there were no caps on insured deposits then investors would leave the Treasury market and put all their money into a bank account that ensures a government guarantee. The investors would be getting the same safety and earn higher yields from being with their local bank.
In a situation where all the banks

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