Deposit Insurance in Banking Industry - Essay Example

Depository insurance can be obtained instantly and they are not traded debts since bank incentives take risks and they have no discipline from market prices. Depository insurance has the role of disciplining the management and reducing the moral hazard that infinite maturity infers that deposits can rapidly disappear; leading to moral hazard; sequential examination also gives a benefit to monitoring such services (Pastré, 2007). Depository insurance helps in ensuring less costly and unnecessary liquidations, duplication of deposits is avoided through monitoring, and less probability of runs on solvent thus reducing shock to the supply of money at the macro level. Depository insurance relates to bank runs in that without monitoring projects may be vulnerable resulting in socially uneconomical projects.

Allman (2006) describes the lender of the last resort as an institution that is willing to give loans as a last option to banks or other financial institutions that are undergoing financial problem that is considered highly risky. Such a firm is usually the country’s central bank. The lender of the last resort produces currency at its discretion to support institutions facing financial problems. It also creates enough capital bases to offset the public desire to switch to money in times of crisis. It also delays the legal insolvency of a firm (Freixas & Rochet, 2008). They also prevent abnormal sales and calling loans. The lender of the last resort reduces the need for banks to hold liquidity as risks are passed to the central bank. It also increases moral hazard known as risk-taking. Since they provide liquidity assistance they help curb the insolvency problem. The lender of the last resort, therefore, eases smooth bank runs by recapitalizing the insolvent banks. This helps financial institutions to enhance their consumer protection.

An economic theory is a concept or an idea put forward to explain various economic aspects that exist in the world economy. Economic theories are those specifically, these theories explain the aspects in line with monetary effects and financial aspects related to the management and utilization of scarce resources exhaustively (Allman, 2006). The major theories that illustrate the existence of banks include:

Economies of scale theory. Here, transaction prices at the core tend to increase this is due to the fixed cost of evaluating assets thus reducing the average costs of trading. This shows that individuals cannot at any time diversify perfectly since bank pool risk and diversified portfolio are cheaper and the payment services are also cheaper (Pastré, 2007). A special situation is where liquidity insurance and economies of scale in risk pulling are experienced. Liquidity focuses on the bank's cashable deposits as assets are long-term and illiquid. Therefore, banks as pools of liquidity give people insurance in opposition to idiosyncratic shocks that they can only observe. Banks also protect borrowers from early encashment of loans.

Asymmetrical information theory. This involves screening to overcome adverse selection whereby intermediaries screen the quality of entrepreneurs and firms as they do in credit analysis. Thus they communicate proprietary messages at lower costs than borrowers and then sell claims to a well-spread portfolio to the investors (Banks, 2005). It also entails monitoring whereby financial intermediaries act like delegated monitors to overcome asymmetrical information and the moral hazard risk. The technology of monitoring provides economies of scale that might be obtained from depository history or even transaction services. Therefore, diversification minimizes borrowing rates especially when the project is too big to be financed alone by the investors. Here, investors need to monitor the intermediary. This theory considers (n) firms,(m) individuals monitoring cost, (c)cost of reneging debt optimality thus requiring nk+cn<nmk.