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Answer: A bank collects large amounts of deposits and reinvests those funds into risky high-yield bonds instead of high-quality bonds with lower returns.
## Explanation **B is correct** because it illustrates moral hazard in deposit insurance. When banks have deposit insurance, they may be incentivized to take on excessive risk since depositors are protected and the bank can potentially earn higher returns from risky investments. In this case, the bank is collecting deposits and investing them in risky high-yield bonds rather than safer alternatives, knowing that if the investments fail, the deposit insurance will protect depositors. **A is incorrect** because increasing equity capital is a prudent risk management practice that reduces risk rather than creating moral hazard. **C is incorrect** because risk-based deposit insurance premiums actually help mitigate moral hazard by charging higher premiums to riskier banks. **D is incorrect** because adjusting interest rates to account for insurance costs is a normal business decision and doesn't represent moral hazard. **Learning Objective:** Explain how deposit insurance gives rise to a moral hazard problem. **Reference:** Global Association of Risk Professionals, Financial Markets and Products (New York, NY: Pearson). Chapter 1. Banks.
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An economist from a central bank is presenting at a banking conference on the characteristics of deposit insurance and the effect on the overall risk profile of the banking system. During the presentation, the economist mentions that using deposit insurance might increase moral hazard risk. Which of the following examples can the economist use to illustrate a moral hazard?
A
A bank increases amount of equity capital it is holding to cover potential losses calculated at 99.9%.
B
A bank collects large amounts of deposits and reinvests those funds into risky high-yield bonds instead of high-quality bonds with lower returns.
C
A bank pays risk-based deposit insurance premiums on all its capital regardless of the amount of interest paid to depositors.
D
A bank decreases the interest rates it pays to depositors to compensate for deposit insurance premiums.
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