Banking refers to licensed and supervised financial and credit institutions. These entities facilitate financial transactions and have the exclusive mandate to provide credit to businesses and individuals. Credit provision is a lucrative business model but contains risk. Such risks are further increased by the business model of financial institutions that allows them to leverage their portfolio by fractional reserve lending and securitization. Besides the traditional financial risk factors, financial institutions can get in trouble for excessive risk taking and regulatory violations. Causes that can often be resolved internally or in civil arrangement. Sometimes however, the risks of connectedness and contagion is so severe that intervention is needed.
Protection is a key word in bank regulation. This applies to every participant of the financial system, from Wall Street to main street. The financial markets affect the real economy. A sophisticated interplay between the principles of the free market economy and the protection of the financial system is needed to safeguard the public interest. Bank risk taking is predominantly controlled by capital regulation. This is because bank capital adequacy prevents bank failure by the provision of a cushion for losses. It therefore reduces moral hazard for owners by making sure that they have substantial capital at risk and thus reduce bailout costs and avoid contagion. Simultaneously, capital regulation also attempts to insure fair competition internationally. Yet there always is a trade off with economic growth.
In the unlikely event that banks fail, systemic failure and public mistrust must be avoided. Statutory administration and deposit insurance seek for swift solutions to maintain confidence in the financial system and keep the real economy thriving. During statutory administration a moratorium with a freeze of account balances and a suspension of payments is often imposed. Resolution may take longer than initially anticipated. Special administrators may then provide restricted access to account balances. This however does not always move immaculate and not all creditors can benefit from these possibilities.
Deposit Protection and Bank Failure
The objective of deposit protection is to avoid panic and stress and provide liquidity to retail customers affected by the closure of their bank. Equity and fairness are important factors to achieve the objectives of deposit insurance in times of financial crisis. The consequence is that not every creditor and account balance is eligible for deposit protection. There is some confusion about this eligibility but in general it is fair to say that unfair advantages and preferential treatments for account holders should be avoided.
Claim eligibility and conditions for repayment are laid down in the local regulation that governs deposit insurance. The scope of the framework depends on the objectives of the regulator for the stability of the local market. In general, deposit protection exclusions in matters of bank failure relate to financial activities like asset management, investing, and insurance. Also, account balances held by public authorities and the tax office do not qualify for coverage of deposit guarantee schemes. In line with local needs, restrictions may also apply to the currencies of eligible deposits and the residency of the creditor. Bank account holders therefore must pay attention to the applicable deposit guarantee scheme and use the scheme to their advantage.