We should not fall into the mindset that problems lurk under every rock and in every loan file. We should justify the balance we maintain as regulators on the basis of fact and critical analysis. Balance in managing deposit insurance means assuring stability in the financial system while addressing the problem of moral hazard that arises from public, or private, deposit insurance. By protecting depositors against loss, deposit insurance virtually eliminates the risk of bank runs and disruptive breakdowns in bank lending that damage the economy. On the other hand, by assuming the risk of losses that would otherwise be borne by depositors, deposit insurance provides incentives for increased risk-taking by bank management, thereby exposing the insurance fund to greater losses.
Moral hazard is a particularly serious concern if the institution is nearing insolvency.
Then, the owners have strong incentives to make risky investments because profits accrue to the owners, while losses fall on the deposit insurance fund. In the 1980s, the balance tipped in favor of stability. In assuring stability, the FDIC was eminently successful. The Basle Committee on Banking Supervision has laid out a framework for assessing an institution's capital adequacy by weighing its assets and off-balance sheet exposures on the basis of counterparty risk. Moreover, recognizing that international banks have been actively involved in trading securities and derivative products, the Committee has developed progressive standards through the use of standardized and internal models to measure the unique market risks of specific portfolios.