4. Few months ago, a major private bank, Bank of UCK, in Prettyland collapsed,

damaging the public confidence to the banking system. The bank's closure led to a

number of bank runs, which were mainly driven by rumors. Even though the rumors

were unfounded, depositors felt panic and lined up outside the banks to withdraw

money. Finally, Bank of UCK was bailed out by the government and the bank runs

were controlled.

The stability of the banking system relies on the level of confidence that

depositors have in the system. Thus the central bank of Prettyland considers to

establish a deposit insurance scheme ("DIS"), which aims to protect small depositors

in case of a bank failure and to reduce the risk of rumor-driven runs. A public

consultation for the introduction of DIS was completed. Now, the Working Group is

formed to carefully review comments received and then advise the design of DIS to

the government. You are appointed as one of the Working Group members and are

responsible for answering the following questions.

a. (10 marks) Some comments concern that "insurance-based system promotes

moral hazard by encouraging depositors and banks to take more risks, which

leads to distorting competition between banks." Discuss this moral hazard issue.

As regards the amount of depositor's deposits to be insured, will you propose full

coverage (i.e., 100% of deposits at the insolvent bank) or partial coverage (i.e.,

30% of deposits at the insolvent bank) to reduce the risk of moral hazard?

Explain your answer.

b. (5 marks) Some views argue that "even without DIS, the moral hazard occurs as

the bailout of Bank of UCK is perceived as being "too big to fail". Actually, an

advantage of DIS over "Too big to fail" is that the former creates fairer

competition. Explain what this argument means.

c. (5 marks) Some views point out that it should be compulsory for all banks to

participate in DIS. If it is voluntary for banks to participate, adverse selection

might arise. Do you agree with this comment? If yes, why? If not, why not?

d. (5 marks) Some proponents of DIS urge that DIS is necessary to protect small

depositors because of asymmetric information between the banks and depositors.

Fully explain the proponents' reason to set up DIS. In addition to DIS, can you

propose one measure to solve the asymmetric information problem?