It is not hard to see why explicit deposit insurance schemes appeal to policymakers. In the short run, since no immediate budgetary expenditure needs to be booked, they represent a seemingly costless approach to reducing the risk of bank runs or panics. Besides stabilizing the financial sector,an insurance scheme may promote other political values, such as protecting small depositors and improving opportunities for small banks to compete with larger institutions for deposits by alleviating potential concern about the fragility of small banks.
However, because deposit insurance reduces the incentive of depositors to monitor banks, it can also encourage excessive risk-taking. Banks can offer high interest rates to depositors, and then try to earn the money to pay those high interest rates by making high-risk loans. In this manner, both banks and depositors can engage in imprudent banking practices, secure in the knowledge that if the high-risk loans do not pay off, their principal is protected by deposit insurance. This pattern is an example of moral hazard: those who are sheltered by insurance from the negative consequences of risks have an incentive to take greater risks. This insight has been persistently emphasized by academics, but mostly dismissed or denigrated by policymakers. However, perhaps one of the most persuasive arguments in favor of establishing explicit deposit insurance is that many governments already provide implicit deposit insurance, since depositors may expect to exert enough political pressure to force taxpayers to supply unlimited deposit guarantees in the case of bank failures. In this case, shifting from implicit to explicit deposit insurance, with explicit limits on coverage, may be a way to limit the government's commitment to depositors.