What is the drawback of deposit insurance facility?

Question

BlackTom AI · Accepted Answer

First, let's restate the question and options to ensure clarity about what's being evaluated.
Question: What is the drawback of deposit insurance facility?
Options:
A. Deposit insurance does not deter contagious runs and panics.
B. DIs are more likely to increase the liquidity risk on their balance sheets.
C. Deposit holder's place in line affects his or her ability to obtain their funds.
D. Even when the DI is in trouble, the deposit holder has no incentive to run.
E. Deposit holders are less likely to panic if there is a perceived bank solvency problem.

Now, evaluate each option carefully:
Option A: Deposit insurance does not deter contagious runs and panics.
- Analysis: This statement captures a known drawback of some deposit insurance schemes: even with guarantees, concern about systemic risk can lead to contagious runs. Critics argue that deposit insurance may not fully prevent panic if the perceived bank solvency problems are widespread, since confidence can be eroded across the system. This option aligns with the idea that insurance is not a foolproof shield against runs in a crisis, which is a legitimate drawback.

Option B: DIs are more likely to increase the liquidity risk on their balance sheets.
- Analysis: Deposit insurance (DI) schemes are typically funded to insure deposits up to a limit and backstopped by the government or a fund. The presence of deposit insurance generally provides liquidity to the banking system by preventing runs, not by increasing liquidity risk on banks’ own balance sheets. If anything, DI reduces the risk of sudden withdrawals, though it may create moral hazard where banks take on more risk, but the statement specifically about increasing liquidity risk on balance sheets is not a standard or direct drawback attributed to DI itself.

Option C: Deposit holder's place in line affects his or her ability to obtain their funds.
- Analysis: In practice, deposit insurance aims to guarantee payment up to a limit without regard to the depositor’s position in a queue. The general design is to ensure all insured depositors are paid up to the insured amount, independent of sequence. This option describes a procedural or operational concern that DI should not cause, and thus is not a typical drawback of deposit insurance.

Option D: Even when the DI is in trouble, the deposit holder has no incentive to run.
- Analysis: This statement is questionable as a drawback since it asserts no incentive to run even when the DI faces trouble. In many frameworks, guarantee schemes can still trigger runs if the guarantee is uncertain or the program is perceived as unstable. However, the wording contradicts common concerns about moral hazard and runs under stress, and it’s not a straightforward drawback associated with DI design. It could be seen as an overly optimistic claim rather than a clear, recognized drawback.

Option E: Deposit holders are less likely to panic if there is a perceived bank solvency problem.
- Analysis: This option describes a potential effect of deposit insurance (reducing panic), which is the opposite of a drawback. A drawback would be something that increases or fails to prevent panic, not something that lessens it. Therefore, this option is not describing a drawback.

In summary, option A presents a plausible drawback of deposit insurance in failing to completely prevent contagious runs and panics, whereas options B, C, D, and E either misrepresent the typical effects of DI, describe non-drawbacks, or state effects that oppose the idea of a drawback. The reasoning distinguishes between how DI is intended to function (stabilize withdrawals and confidence) and the real-world limitations (systemic panic could still occur).

FINS5530-Financial Institution Mgmt - T3 2025

What is the drawback of deposit insurance facility?

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FINS5530-Financial Institution Mgmt - T3 2025

What is the drawback of deposit insurance facility?

View Explanation

Log in for full answers

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