19 December 2008

OECD: Deposit insurance coverage gives rise to moral hazard

Most OECD countries have extended their financial safety nets for banks and financial institutions over recent months. While a helpful step for restoring market confidence, this OECD article highlights the need for policy makers in the coming months to focus on “exit strategies”, especially where unlimited guarantees have been extended.

First, like any guarantee, deposit insurance coverage gives rise to moral hazard, especially if the coverage is unlimited. To keep market discipline operational, it is important to specify when the extra deposit insurance will end, and this timeline needs to be credible.

Second, the co-existence of different levels of protection could give rise to unfair competitive advantages, vis-à-vis other forms of savings or vis-à-vis other deposit-taking institutions that do not enjoy the guarantee.

Third, to make a guarantee credible it is important to specify the manner in which it will be provided. There is the possibility that the capacity of some governments to provide for the guarantee that they have announced or implied in announcements may be questioned.

Looking ahead, a sharper policy focus will have to be placed on “exit strategies”, especially where unlimited guarantees have been extended. In this context, the fundamental question remains whether government guarantees can be a one-off proposition. There may be a general perception that, once extended in one crisis, a government guarantee will always be available during crisis situations.

Full article

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