Deposit insurance refers to the guarantee given by the bank to its depositors that they will receive a certain amount, should the bank encounter losses or become unable to meet its financial obligations. This may be a full guarantee, but more often than not, a specified amount is set as a limit for such insurance.
Banks usually invest the funds deposited by their clients. Such funds may also be used for lending, leaving them with only a small portion of their clients’ deposits. This is called fractional reserve banking.
However, if too many borrowers are unable to meet their payment obligations, the supply of money in the bank is affected, and depositors are at a risk of losing their money. Should depositors detect this, it is highly likely that they will try to get as much of their funds out as quickly as possible. This is called a bank run. Since such a situation can lead to more serious consequences on a larger economic scale, it is necessary to set up a safety net and provide depositors with a sense of security in knowing that they do not stand to lose all of their funds.
While this seems to have a positive effect on both depositors and banks, critics of deposit insurance assert that this gives a false sense of security, leading both parties to engage in risky banking behavior. Some depositors, however, take the extra precaution of distributing their funds among several banks, in order to lower the risk of losing everything in one bank. This is called diversification.
