Explanation:
Moral hazard in the context of deposit insurance refers to the tendency of banks to take on greater risks than they otherwise would because depositors (and potentially the banks themselves) are shielded from the consequences of bank failures. When a deposit insurance corporation is established, depositors know their money is protected up to a certain limit, which reduces their incentive to monitor the bank's risk-taking behavior. Similarly, knowing they will be bailed out, banks may engage in riskier lending and investment activities, such as speculative loans, high-risk securities, or ventures into unfamiliar business areas, that they would not pursue if they were fully exposed to losses. This is the classic moral hazard problem associated with deposit insurance schemes.
Why other options are incorrect:
Q.1096 Following several high-profile bank failures, the Central Bank of a certain Asian country is advocating the creation of a deposit insurance corporation to protect depositors in the event that banks fail in the future. How might the establishment of the corporation create a moral hazard?
A
Banks might refuse to make premium payments to the corporation, crippling it financially in the process.
B
Depositors might channel more of their savings to banks, reducing investments in other sectors of the economy.
C
Banks may increasingly venture into risky businesses that would not otherwise be feasible.
D
The corporation may encourage banks to manipulate accounts so as to appear healthier
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