What are the risks that the banking system may be exposed to as a result of the existence of a deposit insurance institution?

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Deposit insurance institutions are created with the objective of safeguarding the depositor's money in the event of any failure of the bank (wilful or non-wilful).

Like all insurance products, deposit insurance institutions also charge premiums from banks for taking the risk of making good any losses incurred to depositors as the result of the bank failing. The premium rates depend upon the key ratios of the bank such as CASA, Risk weighted capital, NPA etc.

However, one of the major drawbacks of the existence of a deposit insurance institution is that it passes on the moral obligation to safeguard the depositor's money from the banks to the insurance institutions. As a consequence of the insurance institution, banks may become more careless with depositor's money and start lending out to riskier borrowers because they are no longer responsible to make good any losses incurred by the depositors.

Hence, the major risk that the banking system may be exposed to as a result of the existence of a deposit insurance institutition is the granting of loans to riskier borrowers without as much concern about the depositors' money.