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An Alternative to Deposit Insurance

Argentina's financial panic and the run on its banks that ensued, as well as Asia's financial crisis of 1997, have forced a number of countries to consider adopting deposit insurance schemes to protect their citizens' savings. But is deposit insurance the best defense against bank panics?

Deposit insurance was a response to banking crises of the type that plagued the United States until the 1930's. The first explicit scheme was introduced in America after the Great Depression and initially seemed an unmitigated success. Panics no longer occurred, which stabilized the financial system and contributed to sustained post-war economic growth.

Deposit insurance did away with financial panics because bank runs are typically driven by a self-fulfilling prophecy. They occur when a bank's clients fear that most of their fellow depositors will withdraw their funds. Because banks service their depositors on a first-come-first-served basis, those who wait risk being left empty-handed, because the bank may be forced to liquidate its long term-assets at a loss and run out of resources. So fear of a panic can create a panic. This is highly inefficient, because while it is individually rational for depositors to want their money immediately, the bank might have been able to service all of them had they been collectively patient.

Economists call such situations "coordination failures," if depositors could talk to each other and coordinate their actions, they would be able to avoid a self-defeating run on the bank. By guaranteeing that there will be enough resources available for patient clients when they want to withdraw their funds, deposit insurance eliminates the coordination failure. Patient depositors no longer need to worry about others withdrawing their funds because it has no effect on them.