Page 2 of 6

Journal for Studies in Management and Planning

Available at

http://edupediapublications.org/journals/index.php/JSMaP/

ISSN: 2395-0463

Volume 03 Issue 02

February 2017

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 39

is thus divided into five sections. Section

one is introduction to the topic, section

two reviews the theoretical literature on

the topic, section three is a review of

selected empirical studies, section four

contains the papers position on the topic

and section five has summary and

conclusions.

2. Review of Theoretical Literature

Literature in insurance and finance is

replete with deposit insurance its

usefulness, contradictions and

contraindications. Countries all over the

world have been delving into one form of

deposit insurance or the other. Some

favour implicit deposit insurance and

others explicit and full cover deposit

insurance. Whichever side of the divide

one finds itself, it is noteworthy that the

very essence of deposit insurance is

ensuring financial system stability by

protecting depositors’ fund.

The purpose of the deposit insurance

system is to protect depositors and

guarantee the settlement of insured funds

when a deposit-taking financial institution

can no longer repay their deposits, thereby

helping to maintain financial system

stability (NDIC Act No 16, 2006 -which

replaced the NDIC Decree No 22 of 1988).

Ogunleye (2002) describes a deposit

insurance scheme as a financial guarantee

and safety net to depositors in the event of

bank failure. He further puts up that the

scheme is designed to protect the banking

system from instability occasioned by runs

and loss of confidence.

Today, deposit guarantees have become

the tradition not the exception, in virtually

all banking systems across the globe.

There are six variants from which nations

make their choices. First, they can enact a

law expressly denying deposit insurance

protection, as New Zealand has done.

Second, they can expressly deny deposit

insurance, but give priority to depositors

over other claimants in failed bank

insolvency proceedings. This is the

approach in Australia. Third, countries can

be ambiguous about implicit coverage

(which is the default position if there is no

law on point). Fourth, countries can signal

implicit deposit guarantees through their

actions by consistently bailing out failed

banks and their depositors. As of 2003, 93

countries reported using this approach.

Fifth, nations can legislate explicit deposit

guarantees with coverage limits.

By 2003, eighty-eight countries had

adopted this approach. Today, explicit

deposit insurance is found predominantly

in Europe, Central Asia, Latin America,

and the Caribbean, but relatively rarely in

sub-Saharan Africa. Finally, countries can

opt for explicit deposit guarantees with full

coverage. This last approach occurs rarely

and is usually reserved for severe systemic

financial crises. In 2003, only the

Dominican Republic, Indonesia, Malaysia,

Thailand, Turkey and Turkmenistan had

full explicit coverage (Demirgtuc-Kunt

and Kane, 1999)

The benefits of deposit insurance

notwithstanding, empirical and theoretical

evidence abound as to the fact that deposit

insurance creates moral hazards.

Moral hazard represents one of the

negative fall outs of deposit insurance

especially the explicit form of deposit

insurance. Paul Krugman(2008) describes

moral hazard as “any situation that

someone makes a decision on how much

Page 3 of 6

Journal for Studies in Management and Planning

Available at

http://edupediapublications.org/journals/index.php/JSMaP/

ISSN: 2395-0463

Volume 03 Issue 02

February 2017

Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 40

risk to take and someone else bears the

cost if anything goes wrong”

It is argued that explicit deposit insurance

increases the risk taking incentives of

players in the financial system and makes

depositors complacent in monitoring their

deposits with banks.

McCoy (2007) puts up that

“Deposit insurance is a tightrope act. On

the one hand, explicit deposit insurance

can significantly reduce the incidence of

bank runs or even stop runs altogether in

countries with strong institutions and

proper safeguards. On the other hand,

when not done carefully, explicit deposit

insurance can fuel bank crises by giving

banks perverse incentives to take

unnecessary risk”

Freixas and Rochet(1997), Boot and

Greenbaum(1993) as well as Matutes and

Vives all agree that deposit insurance

creates moral hazard by becoming a

disincentive for insured claim-holders to

monitor the activities of bank

management. It is further held that bank

managers will rationally maximise bank

value by taking the return element of the

deposit insurance into account which

invariably would increase their propensity

to take risks.

Wheelock (1992) argues that since deposit

insurance absorbs part or all of the losses

when a bank fails, it seemingly becomes

an equivalent of a subsidy to take risk.

Matutes and Vives(1995) and Tirole and

Dewatripont(1993) tied the degree of

moral hazard to the observable nature or

otherwise of the performance of the banks

in the system. If the asset risk and bank

performance are unobservable, risk is

maximized even without deposit

insurance. They place the role of

monitoring on the doorstep of the non- deposit creditors who should also build

public safety net through monitoring of

assets and leverage risks which are not

observable to deposit creditors. This line

of arguments plays down the excess hype

on moral hazards as placed only on

explicit deposit insurance. It is believed

that risk taking by bank managers is not

only fuelled by deposit insurance but by

other factors outside the scope of this

work.

3. Review of Empirical Studies

Isabella D, Tchudjane K, amine

Tarazi(2011) did a study on Deposit

Insurance, Moral Hazard and Market

Discipline with evidence from Central and

Eastern European banks. The work

focussed primarily on the impact of

explicit deposit insurance scheme on risk

taking of banks and on the effectiveness of

market discipline. A sample of 203 banks

from 10 countries in Central and Eastern

Europe was used. The study discovered

among other things that explicit deposit

insurance introduced in these countries in

the 90s led to a higher bank risk taking

incentives and higher default risk. It was

also found out market discipline exerted

through interbank deposits appeared

effective in the presence of explicit deposit

insurance. By credibly excluding some

creditors from insurance, market discipline

grew higher and became a cushion against

the incentive to unwarranted risk taking.

The above empirical proposition represents

the views of too many scholars, Demirguc- Kunt, Detragiache (1999, 2000),

Wheelbock (1992), Freixas and

Rochet(1997), Boot and