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A key function of deposit insurance is to provide a credible safety net for depositors which is beyond doubt, including in times of crisis. At the same time, deposit insurance, like any insurance scheme, raises moral hazard concerns. When depositors are protected by a supranational deposit insurance scheme, participating countries may be less strict with national banking policies. It is important to address these moral hazard concerns.
However, current proposals for a European Deposit Insurance Scheme (EDIS) with national compartments to address moral hazard may defeat the purpose of the scheme. The idea of national compartments is that the first part of the loss is borne at the national level, only above a certain threshold are losses shared at the supranational level.
The viability of particular national compartments may be questioned during a crisis and thereby worsen the crisis dynamics. A good deposit insurance should be a beacon of stability during a crisis, not a source of lingering doubts.
It is important to contain the impact of the failure of one or more bank(s) with subsequent deposit insurance payouts on the remaining banks. Such payouts can weaken the banking sector, as banks fund the scheme both ex ante and ex post. A large failure with uncertain payouts (the exact losses at the failing bank(s) are not directly known because of fluctuating asset values in times of crises) can set out a negative trust spiral in the case of smaller deposit insurance funds.
Finally, the adverse selection and moral hazard aspects of deposit insurance should be addressed to minimise the exposure of the government as fiscal backstop of deposit insurance. To counter adverse selection, weak banks should not be allowed in. Existing banks need to be cleaned by removing, or full provisioning of, non-performing loans. Once banks are in, supervisors should monitor them in the day-to-day supervision.
Author concludes that moral hazard concerns can be alleviated through a country-specific component in the risk-based premium for deposit insurance and limits on sovereign bond exposures on bank balance sheets. But proposals to maintain national compartments in a new European Deposit Insurance Scheme are self-defeating, as such compartments can be destabilising in times of crisis.