This is when governments give a guarantee to savers that if their bank goes bankrupt, the government will pay them all or some of their savings. The government offers bank deposit protection to increase the confidence in the banking system.
If people felt banks could go bankrupt during a financial crisis – then they could lose all their savings. This would then cause a rush to withdraw money – causing a collapse in confidence in the banking sector. Even a small loss of confidence in the security of bank deposits could lead to a ‘bank run’ – a situation where people seek to withdraw savings.
The problem is that banks only keep a certain percentage of savings in liquid cash. They assume most people will not want to withdraw overnight – this allows the bank to lend out deposits in more profitable lending.
Example of bank deposit protection
After the credit crunch, in the UK, the government increased the guaranteed savings from £35,000 to £50,000. This means – even if your bank goes bankrupt you are guaranteed £50,000 from the government. However, during the credit crisis of 2008, countries like Ireland and Germany gave unlimited protection to savers.
The problem with protecting all bank deposits is that it can make the government liable for a lot of savings. Also, it is feared that guaranteeing savings may encourage risky behaviour by banks. This could lead to moral hazard where banks have less incentives to behave carefully.