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Deposit insurance: Backing up the Banks

Emerging market governments were forced to bail out collapsing banking systems at huge public cost following the economic and financial crises of the 1990s and 1980s. Many are now considering setting up deposit insurance systems to bring more transparency and stability to implicit sovereign guarantees for banks. Oddly, in the US, where deposit insurance was first established and whose model emerging markets are often encouraged to follow, deposit insurance is being reconsidered. On its own, it’s no safeguard against banking crises.

Author: James Smalhout "Countries can be divided into two groups," says Manuel Conthe, the World Bank's vice president for financial sector development, "those who have deposit insurance and know it, and those who also have deposit insurance but don't know it until, of course, there is a banking crisis."

Ignorance can be anything but bliss in these situations, as countries like Indonesia, Korea and Thailand found out in 1997. They had been cruising merrily along without any formal back up for their banks, before financial chaos began racing through Asia. Those governments then had little choice but to declare blanket guarantees in order to quell the panic. Indonesia spent 50% of one year's GDP bailing out its banks, as a result. South Korea and Thailand also saddled themselves with enormous new burdens.

Mavens like to compare deposit insurance to a circus safety net. "The most immediate goal is to prevent the acrobats from going splat and to spare the audience from seeing the horror of a terrible accident," says Edward Kane, an economist at Boston College and the unofficial dean of deposit insurance analysts everywhere. "But safety nets also make it rational for acrobats to perform the tough, yet do-able stunts that attract people to the circus."

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