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Answer: Providing a certain amount of protection to a depositor against losses arising from a potential bank failure.
**Providing deposit protection** creates moral hazard because: 1. **Depositors** have less incentive to monitor bank risk-taking since their deposits are insured 2. **Banks** may take on more risk knowing that depositors won't withdraw funds due to insurance protection 3. **Risk-taking behavior** increases as the safety net reduces market discipline **Why other options reduce moral hazard:** - **A**: Borrowing limitations reduce excessive risk-taking - **B**: Risk-based premiums align costs with actual risk - **C**: Capital requirements force banks to internalize risk costs
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To maintain confidence in the banking system, many countries have introduced deposit insurance. However, a serious consideration in deposit insurance that can make the insurance contract riskier is the so-called moral hazard problem. Which of the following actions is most likely causing the moral hazard problem in the deposit insurance scenario?
A
Enforcing strict limitations on borrowing.
B
Setting the risk-based deposit insurance premium.
C
Implement regulatory measures that ensure banks maintain sufficient capital reserves in proportion to the risks they undertake.
D
Providing a certain amount of protection to a depositor against losses arising from a potential bank failure.