Financial institutions including commercial banks face an array of risks to the extent that risk management has become a major concern for managers of financial institutions.
The two risks on the desk of a bank’s chief executive are credit risk and liquidity risk. Both risks can send a bank into insolvency - exposing depositors and shareholders to losses.
These two risks are interlinked. The liquidity risk is found on the liability side of the balance sheet of a bank. It occurs when depositors unexpectedly seek to immediately withdraw their deposits.
But banks cannot be keeping enough cash in their vaults to meet that kind of demand; and in any case, most deposits are in the form of a loan to those who borrowed from the lenders.
It will be unwise of a bank to recall loans because that will hurt its reputation. The liquidity risk on the asset side of the banks’ balance sheet is due to off-balance sheet loan commitments - a commitment to a customer to borrow funds on demand, and when the customers exercise that ‘right’ then the bank must fund that loan immediately.
Financial markets and specifically depositors in banks are worried about the risk that a bank might dishonour depositors’ request for cash. If that happens, then every depositor in the affected bank becomes worried and joins others who want to withdraw their cash.
The depositors will effectively run to the bank to withdraw their money, also called run on deposits.
What complicates the situation is the clause that when depositors want their money back, they are paid according to first come, first-serve procedure; again, depositors are forced to literally run to the bank for their deposits.
This is what happened when news spread that some banks are exposed to solvency. Some of the affected banks closed doors, in some instances temporarily.
When the Central Bank is informed of the damaging effects of deposit run; the extreme end of a deposit run is a collapse of the entire banking system. Nobody benefits from that.
The external cost of runs on the safety and soundness of the banking system cannot be imagined.
For example, savings and investments will reduce whenever citizens cannot trust their money with commercial banks.
The central banks are aware that financial markets must enjoy certain liquidity to be able to settle and clear operations within their system and win financial market players’ confidence.
The key word here is ‘market players’ confidence, and in the case of banks, depositors confidence.
There will be no commercial bank without a depositor.
Therefore, banks and regulators have proposed a safety net to win depositors’ confidence. One such a device is insuring the amount deposited at the bank.
The deposit insurance is meant to help lessen the problem of bank runs because it provides assurance that deposits in commercial banks are safe, even in cases when the lender is in financial distress.
However, with time, researchers have identified the negative side effects of deposit insurance; and this is the moral hazard and adverse selection problem associated with insurance.
The adverse selection problem occurs because individuals and institutions who are most in need of insurance are most likely to acquire insurance.
A patient with a chronic illness is more likely to apply for a health insurance policy than the one who is healthy.
Moral hazard is the loss by an insurer when the provision of insurance encourages the insured to take more risk.
In the case of a bank, the loss associated with deposit insurance is not restricted to the insurer but extends to bank depositors.
Sunders tells us that ‘Moral hazard occurs in the depository institution industry when the provision of deposit insurance or other liability guarantees encourages the institution to accept asset risks that are greater than the risks that would have been accepted without such a liability insurance.’
The point is that deposit insurance can encourage bank managers to invest in too risky assets that have the potential to send the bank into insolvency.
We have to debate whether, and to what extent do we need deposit insurance.