Question at position 24 The existence of deposit insurance can increase the likelihood that depositors will need deposit protection, as banks with deposit insurance arelikely to take on greater risks than they otherwise would.are placed at a competitive disadvantage in acquiring funds because they pay the premium. likely to be too conservative, reducing the probability of turning a profit.to regard deposits as an unattractive source of funds due to depositors' demands for safety.

Question

BlackTom AI · Accepted Answer

Deposit insurance creates a moral-hazard incentive: when depositors’ funds are protected, banks face weaker market discipline and so are likely to take on greater risks than they otherwise would.

1. Relevant knowledge points and concepts
- Deposit insurance: a guarantee (explicit or implicit) that depositors will be repaid even if a bank fails.
- Moral hazard: when protection from risk reduces the incentive to avoid that risk.
- Market discipline: depositors monitoring banks through withdrawal behavior; weakened if deposits are insured.
- Regulatory responses: risk-based premiums and supervision attempt to offset moral hazard but cannot eliminate it completely.

2. Step-by-step reasoning
Step 1: With deposit insurance, small depositors no longer lose their funds if a bank fails, so they are less likely to monitor a bank’s risk-taking or withdraw at early signs of trouble. 
Step 2: Because depositors are insulated, the bank’s cost of funding does not rise when it undertakes riskier activities, removing a market penalty for risk-taking.
Step 3: Bank managers and owners therefore gain incentive to shift toward higher-return, higher-risk investments (risk-shifting) because upside accrues privately while downside losses are limited for insured depositors and socialized through the insurance system.
Step 4: This increases the probability that depositors will actually need deposit protection, creating a feedback loop consistent with moral hazard.

3. Calculations
No numerical calculation is required for this conceptual question.

4. Why the correct answer is correct
The choice "likely to take on greater risks than they otherwise would" directly describes moral hazard: deposit insurance reduces depositor monitoring and market discipline, encouraging banks to increase risk to capture higher returns, thereby increasing the chance they will require insurance payouts.

5. Why the other options are incorrect
- "are placed at a competitive disadvantage...because they pay the premium." Incorrect: premiums are typically small or risk-based; moreover, implicit guarantees can offset explicit premium costs. This does not capture the main effect.
- "likely to be too conservative, reducing the probability of turning a profit." Incorrect: insurance removes downside for depositors and thus encourages risk-taking, not excessive conservatism.
- "to regard deposits as an unattractive source of funds due to depositors' demands for safety." Incorrect: depositors’ demands for safety are what deposit insurance addresses; banks do not avoid deposits for that reason.

6. Conclusion
Therefore, the correct answer is: likely to take on greater risks than they otherwise would. This matches the provided answer.

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