Georgia is among a few countries in the world that do not have a deposit insurance system in place. Does the country need to have such a system? Or is deposit insurance likely to do more harm than good? The answer is not as clear-cut as it may seem.

Deposit insurance is a relatively new phenomenon in international banking. For example, in 1974 only 12 countries had explicit deposit insurance schemes, while in 2003 the number already rose to 87. The United States was one of the first countries in the world to establish such as scheme. The Federal Deposit Insurance Corporation was created in 1933, after the debacle of widespread bank failures and bank runs of the Great Depression.

The purpose of the deposit insurance system is clear: banks operate on a fractional-reserve principle, in which only part of the depositors’ money is available for withdrawal at any given time. The rest is loaned out to businesses, governments, and private consumers, typically on a long-term basis. The value and quality of the loans are not easily observable to the depositors. If the depositors become concerned and show up all at once to claim their funds, even the most prudent banks would fail.

This is essentially what happened during the Great Depression when more than 10,000 banks collapsed in the US between 1929 and 1933. Banking collapses in turn force investment projects to close down abruptly, accelerating the decline in output, and causing even more instability.

Arguably, a simple deposit insurance scheme could act to prevent a vicious cycle of bank closures and output losses. In addition, deposit insurance is usually a popular political step and a virtually costless policy change at the time of implementation.

On the other hand, the critics of deposit insurance argue that the scheme can in fact destabilize the financial system instead of strengthening it. One major challenge is overcoming moral hazard - the problem when banks, relying on explicit government guarantees, have a greater incentive to take undue risks. The depositors themselves contribute to the problem by being more complacent about the risk-taking behavior of the banks, knowing that the deposits are protected by insurance.

The problem of moral hazard has been analyzed extensively in connection with well-known cases of bank crises around the world. In fact, the existing research on the subject (for example, Demirgüç-Kunt and Detragiache (2002) caution that explicit deposit insurance can in fact increase the likelihood of banking crises if coupled with a weak institutional environment.

Does this mean that a deposit insurance scheme is not a good idea for Georgia? Not necessarily. First, one may argue that for better or worse, such a system is already in place in the form of an implicit guarantee. In Georgia the banking sector is highly concentrated, implying that the majority of deposits are held in only a few banks. The failure of even one of them would result in substantial political pressure on the government to step in and compensate the depositors. Knowing this, depositors and banks can behave as if the deposit insurance guarantee were already in place.

Would the creation of an explicit deposit insurance scheme simply be an acknowledgment of the existing reality, or will it provide a more direct benefit? Arguably, one of the benefits can arise from the potential effect on domestic savings behavior.

Georgia is one of the countries where domestic savings rates are very low. The gross domestic savings in Georgia was 2.51% of GDP in 2011 (as compared, for example, to 6.81% of GDP in neighboring Armenia). The rate of savings in the banks is lower still. Clearly, this arrangement is not optimal for a developing country. Lack of bank savings can lead to low rates of domestically financed investment, high-interest rates, and ultimately poor long-term growth prospects for the country as a whole.

According to the Savings Behavior Assessment Survey in Georgia, 2011, 60% of respondents declared their willingness to deposit money in a bank, provided that the deposit insurance is offered. Potentially, this is a tremendous improvement, considering that according to the same survey only 6% currently keep their savings in the banks.

In light of this evidence, it may be beneficial for Georgia to adopt an explicit deposit insurance scheme. Yet, the policymakers would be well advised to be vigilant about the strength of the institutional environment and banking supervision. There is enough evidence to suggest that lack of adequate oversight coupled with deposit insurance guarantees may indeed destabilize the financial system, and ultimately do more harm than good for the country.