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?