ise to moral hazards if the system is not designed properly. Policy makers choose either explicit or implicit form of protection. Explicit deposit insurance scheme is a formal system, it clearly specifies the amount of compensation to each depositor. UK and most of the other European countries have a explicit guarantee system. In implicit guarantee system the government protects depositors by paying the compensation directly to the depositors. The government decides the compensation limit.
RATIONAL FOR DEPOSIT INSURANCE
The deposit insurance system has direct and indirect rationale. The direct rationale is to protect the depositors against the risk of bank failure. The depositors are the consumers of the financial institutions, so it is necessary to protect them from loss. The indirect rationale is deposit insurance system discourages the bank runs, as the safety net arrangement provides confidence to depositors on their money, there will be only few reasons for the depositor to run on the bank. A bank run can turn a solvent bank in to insolvent bank, it can also run across the borders and cause financial instability. Bank runs at one place can causes the depositors at other banks to panic and go for early withdrawal. Various economic studies show a well designed insurance arrangement can stop the run on the bank and it will reduce the systemic crisis. In absence of this system even false information on a bank will create a bank run. At the time of bank failure government uses the insurance system as tool to stop the spread of failure by providing a full guarantee to the depositors. This system will also help in increasing the savings accounts and encourages the economic development. The deposit insurance system at the time of bank panics will make the entrepreneurs and household to carry on their normal system of work with out any panics as their funds are secure, so this helps in smooth progress in the economy.
A well-designed deposit insurance system can be, at best, just one component of sound financial system. (Gillian G.H.Garacia, 2000)
MORAL HAZARDS OF DEPOSIT INSURNCE
We know the deposit insurance has been very successful in protecting the depositors and contributes to the financial stability. The deposit insurance on the other hand can undermine the market discipline of the economy. Banks with generous deposit insurance system will indulge in riskier activities, they profit by involving risky strategy and transfer the loss of risk to the insurer. This practice will affect the market discipline and financial stability of the country. Secondly deposit insurance system do not give incenti