What is the risk-based Deposit insurance’
Risk-based, Deposit insurance is insurance with premiums that reflect how prudently banks in investing their customers ‘ deposits. The idea is that fixed rate Deposit insurance shelters banks from their true level of risk, and contributes to wrong decisions and moral damages. While not all Bank failures is the result of moral hazard, risk-based Deposit insurance is believed to prevent the bankruptcy of banks. Banks that have higher risk pay higher premiums.
Penetration of risk-based Deposit insurance’
Risk-based Deposit insurance became the standard after the Federal Corporation on insurance of deposits (FDIC) Improvement act of 1991, passed after the crisis of the savings and loan. It required the FDIC to switch from a program mini-course for Deposit insurance by 1994.
The FDIC, whose main aim is to prevent run on the Bank scenarios that devastated many banks during the great Depression, uses Deposit insurance premiums that it receives from banks for the financing of the Federal program of Deposit insurance. This program protects consumers by Deposit insurance up to $250,000 in member-banks in case of bankruptcy of the Bank.
Checking accounts, savings accounts, certificates of Deposit (CDS) and money market accounts is usually 100% covered by the FDIC. Coverage applies to trust accounts and individual retirement accounts (IRAs), but only those parts that are suitable for different types of accounts listed previously. FDIC insurance does not apply to products such as mutual funds, annuities, life insurance, stocks or bonds. Contents of safe Deposit boxes are also not covered by the FDIC. Cashier’s checks and payment orders issued by the Bank.
Examples of moral hazard
Moral hazard is a situation in which one party to a contract commits risky acts or does not act in good faith, because he knows the other side does not bear any consequences of that behaviour. Moral harm is typically applied to the insurance industry. Insurance companies are concerned that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking that leads them to pay more claims.
In business, a typical example of moral hazard include government assistance. At the end of 2000-ies, in the throes of the global financial crisis, years of risky investments left many major American corporations are in danger. Ultimately, the U.S. government considers some of these companies too big to fail and rescued them. The reasoning was that to allow the business important to the economy cannot push the United States into a depression.
The Dodd-Frank of 2010 has tried to mitigate moral hazard in too-big-to-fail corporations, requiring them to develop plans on how to proceed if they got into financial difficulties.