Financial System


Financial system of a given country in broader category includes financial intermediaries, financial markets and regulators. The well functioning of such a system can play a great role in the development steps a country is undertaking. Unfortunately, enormous literatures shows underdevelopment of this system has been a headache for policy makers in Developing Countries. As the weak financial system lead to a declined effectiveness of the monetary policy in LDCs, UNCTAD in its 2009 LDCs report proposed as alternative approach governments should take Fiscal Policies as a leading role while the financial sector complements development strategies through providing liquidity. (UNCTAD, 2009)

Banks and Insurance companies are major financial institutions through either accepting deposits or selling insurance policies. In particular as a financial intermediates Banks play a great role in the financial sector development of a country. Some activities undertaken by these institutions include easy transactions, credit creation, risk trading, mobilizing funds, transferring time horizon of funds and the like.

In order to do more effectively their activities the actors here Banks in particular would set up corporate financing scheme. Even though the conceptual frame work of corporate financing tells us a need for homogeneity interaction between different entities involved, it is hard to find such flow of interests on the same direction. This might threaten depositors who have put their moneys in banks in return of interest rate and precautionary motives.

With this regard of contradiction in cooperate financing scheme one major problem to be addressed in the sector is ‘How to guarantee depositors so that the banking system can continue its role of stabilizing financial system'. Addressing this problem can be taken as a signal for confidence strengthening on the system and domestic revenue mobilization can be facilitated. Furthermore, this paper raises a research question of 'Is a Deposit Insurance scheme the way to gain the trust of depositors in the developing countries?' If so what types of deposit insurances are recommended? Taking the research question as a central point the paper has a structure that follows by review of literature and empirical findings. And finally concludes on the bases of literatures and findings.

The Agency Paradigm Theory

“A modern corporation is a team effort involving many players, including management, employees, shareholders, and bondholders. The members of this corporate team are bound together by a series of formal and informal contracts to ensure that they pull together.” (Brealey/Myers/Marcus, 2009, p. 691). Even though in concept the quote from Brealey holds true, in real practice one observes a deviation in corporate financing from conceptual frame work. This is due to the conflict in interest that exists among actors mentioned above. We call this conflict in general Agency Paradigm or Theory.

According to Herring Richard J., 1998, p. 389-390, depository institutions (Banks and Savings and Loan Institutions) has faced a banking crisis in early 90's in US. Among from the three major reasons one reason for the Banking crisis was Moral hazard of the Safety Net system practiced then. As depositors were explicitly insured on their deposits by the Safety net program, they were not much into raising questions and monitoring the risk of their deposits. Furthermore the action of the Fed as LOLR (Lender of Last Resort) for Banks those were already insolvent and categorized as “too-big-to-fail” gave depositors a confidence on implicit deposit insurance on their deposits.

Likewise most developing countries governments require banks to adopt and sign a written contract of agreement on deposit insurance. The reason behind this action is to minimize systemic failure[1] of the banking system (Cull, Robert J., et al, 2005, p. 44). It is expected to minimize the risk of depositors losing values for their assets (cash) and give them confidence on saving (depositing). This is presumed to increase the role of banks in economic growth through the money multiplier effect to meet the money or the capital demand of economic actors in particular investors and consumers.

For this high expectation of deposit insurance to play a role in the financial development one should look at the appropriateness or inappropriateness structure of the banking system in consideration. With a weak structure of a banking system for instance weak monitoring and supervision of banks, deposit insurance can create a moral hazard for the banks to get involved in highly risk activities at a cost of government covering if they encounter failures to fulfill their liabilities to depositors (Cull, Robert J., et al, 2005, p. 44).

“The natural financial objective of the corporation is to maximize current market value. Managers who consistently ignore this objective are likely to be replaced.” Brealey /Myers/Marcus, 2009, p. 13. Even though this is the ideal objectives it has been seen the deviation of management body in the Banking system from its objective, referred to us the Agency Theory.

For further illustration of Agency paradigm, if we take for instance a frame work of three entities, i.e. equity holders (bank owners), debt owners (bank depositors) and bank managers, the decision made by bank managers usually are sub optimal. For every investment opportunity bank's face, we can point out two characteristics: rewards (loan profitability) and risk or volatility (loan quality). Cull, Robert J., et al, 2005 characterized bank managers who have the delegation of the equity holders (bank owners) seems to take on much riskier investment projects portfolio decision to yield a high rate of return if successful. These too lose behavior of Bankers increases the probability of high financial volatility which may lead into bank crises and hinders financial sector development.

Cull, Robert J., et al, 2005, pointed out both explicit deposit insurances (EDIs) and implicit deposit insurances (IDIs) had an impact on Bank manager's behavior in taking a risky investment projects. EDIs are insurances where the government officially announces that the Banking system of the country is backed by deposit insurance through legal binding contracts. While the IDIs are those which reach out for depositors in the time of bank failure without an existence of pre written document for the actions to be taken. These actions were among the reasons for the Bank shocks observed in early 90's in US B&S&L institutions which of course had a counter part in financial development because of high financial instability.

Determinants of Banking Sector Stability

The overall environment of the banking sector such as political, economic and institutional settings plays a great role for the sector performance. In the case of EDIs covered countries difference in political system affects decision made on their design and adoption. The main reason tied to these difficulties is the existence of conflict of interest as illustrated in the Agency Theory that makes the political process tricky and more complex. Moreover, Theory of incentive-conflicted intervention also explains the public and private interests are always in conflict standing on opposite side of a road as stated in Demirgc-Kunt, Kane and Laeven, p.3, February 2006. In other words the theory points a clue that the regulatory decisions from the government sides usually are the result for such interest-group competition. The election campaign support pressures on politicians by powerfully organized groups, which expect their rewards aftermath of the campaign are best examples. Hence Democratic political system lends an ear to such minorities but powerful groups than Socialist political system. And of course deposit insurances has been seen benefiting riskier banks (usually a shareholder of lobbying group), who play the game well with strategies that enables them to access subsidies to be bailed out by tax payers if they find themselves on that position.

Secondly, the economy can have an impact on banking sector stability through two channels: government activities and capital account condition. Fiscal deficit of a government (specifically if incurred due to non-development activities) hugely alters the direction of capital flows from private sector. Most developing countries governments are characterized by high demand for loan on their fiscal deficit. This further has an upward push on the interest rate even for the available fund that the private sector could have take for investment activities. In India in the year 2000 public debt[2] record was beyond the mark of 50 percent of GDP, a historical event of political competition that led to expensive campaign promises to important interest group of the government at the time (Roland, C., 2008, p.45.). This distorts banking sector provision of capital for future development plus it washes depositors trust in the system.

The extent of capital account liberalization can have an influence on bank stability as well. On one hand due to contagious financial crisis which originate elsewhere, the banking sector of the country could be affected if fully liberalized (the current situation of financial crisis). On the other hand if capital account liberalization is limited in particular for house hold citizens, the sectoral investment will remain in home country which hinders excessive out flow of capital (capital shortage is one problem for LDCs development) and creates relative stability in the banking system.

Thirdly, Demirgc-Kunt, Kane and Laeven, p.3, February 2006 mentioned stability of the banking system falls under sever attack for generous design featured deposit insurance where there exist poor and malfunctioning institutional settings. These poor that have executive power for licensing, supervision and control over banks and only paper written but not implemented Bank Regulation Acts[3]

Factors affecting Explicit Deposit Insurances

As it has been discussed in the Agency Paradigm Theory whether the deposit scheme a country is adopting as EDIs or IDIs it will be a matter of time for economic agents (bank managers, depositors, bank shareholders) behavior to be affected. Demirgc-Kunt, Kane and Laeven illustrated in their findings almost every country adopts deposit insurance scheme, at least for being an implicitly to get political acceptance as a government (See Annex 1). From 181 countries data set 87 adopted EDIs while the remaining IDIs. Countries in Low Income category covered 11.49 percent among EDIs adopted countries and 54.83 percent (more than half) among EDIs adopted countries. Region wise from 46 SSA countries 51 are under IDIs. (See Annex 2) Here it can implicitly be forwarded that the adoption of EDIs has a positive trend with countries joining the higher income category.

Hence it is better to make deposit insurance in an explicit form in low income countries (developing countries, if we take the category as equivalent) as whether liked or not there exists an implicit one. And the Moral Hazard negative impact on financial system development that rises from the IDIs is much higher as there is no legal binding and regulatory bodies involved. With this being said what could be determinants for Explicit Deposit Insurances to undertake effective role in enhancing the financial system in the developing world?

From the cross-country deposit insurance study undertaken by Demirgc-Kunt, Kane and Laeven, 2006, explicit deposit insurances need a careful design not to be attacked from lobbies on the governments' officials or regulatory bodies. In addition they pointed out a pre crisis explicit deposit insurance set up is preferred to minimize the exposure to such lobby groups. In addition studies show that EDIs' extent and amount coverage greatly matters in their role in the sector. The institutions the insurances cover or the size to be small for depositors to be skeptical or to be unnecessarily big for banker to get involved in risky speculation activities are some of the illustrations. A co-insurance [4] EDIs schemes would be advisable to get depositors precautionary choice on banks in the sector and to get their eyes over bank management body activities.

Further Cull, Robert J., et al, 2005, with their generalized Tobit model estimation found out the likely negative impact of “generous government-funded deposit insurances”[5] on financial system of the countries where there is absence of regulatory body. Even if this regulatory body exists its autonomy to set independent legal frame work prior to crisis to combat Moral Hazard that may result in “generous government-funded deposit insurances” affects the functioning of EDIs.


From the literatures and findings this paper has gone through the following conclusions can be deduced:

  • The well functioning of the overall financial system depends on political, economic and institutional settings of a country
  • To combat bank failures and enhance financial system development an Explicit Deposit Insurance (EDI) schemes will be preferable
  • The effective functioning of EDIs depends on the institutional arrangement of a country which includes politically independent regulatory bodies, participation of depositors (co-insurance) and of bank share holders


  1. Brealy/ Myers/Marcus, 2009, Fundamentals of corporate Finance , 6th ed., McGRAW-HILL International Edition
  2. Cull, Robert J. , Senbet, Lemma W. and Sorge, Marco., February 2005, Deposit Insurance and Financial Development, Journal of Money, Credit, and Banking, Volume 37, Number 1,
  3. Demirgc-Kunt, A., Kane, Edward J. and Laeven, L., February 2006, Determinants of Deposit Insurance: Adoption and Design, WB Policy Research Working Paper 3849
  4. Herring Richard J., 1998, Financial Times, Mastering Finance, The Complete Finance Companion, Banking Disasters: Causes and Prevention
  5. Ronald, C.( Dr.), Banking Sector Liberalization in India: Evaluation of Reforms and Comparative Respective On china, Physica-Verlag-A Springer Company
  6. Treasury Direct, April 9, 2009, Frequently Asked Questions about the Public Debt, [Accessed on October 22, 2009]


Annex.1 Deposit Insurance Coverage around the world (as of 2003)

Source: WB, Demirgc-Kunt, Kane and Laeven, 2005, p. 15

Annex.2 Deposit Insurance Coverage around the world

(Left Explicit Deposit Insurance, Right Implicit Deposit Insurance, according to Region)

Source: WB, Demirgc-Kunt, Kane and Laeven, 2005, p. 15

  1. “Systemic failure is a simultaneous collapse of sizable portion of the banking system possibly extending to non-banking financial sector as well as to financial markets”, Cull, Robert J., Senbet, Lemma W. and Sorge, Marco, p. 44, 2005
  2. Public debt is accumulated public deficit [public deficit: a fiscal year difference what a government takes in from tax and other revenues referred as receipts, and the amount of money the government spends referred as expenditure] plus off-budget surplus [which is the surplus in social security program plus postal service], Treasury Direct,
  3. “These regulation acts usually provides banking regulations, the banking acquisitions, transfer of undertaking or acts for nationalization” Roland, 2008, p. 42-47
  4. Co-insurance EDIs Schemes are insurances where the depositors carry a proportion of the insurance burden when failure in the financial system occurs, Demirgc-Kunt, Kane and Laeven, 2005, p. 6-7
  5. “Generous government-funded deposit insurances” are characterized by high amount of insurance coverage per depositor , wider coverage extent on types of different deposits (foreign currency deposit, interbank deposits, saving accounts, current accounts, etc), high source of funding by governments Cull, Robert J., et al, 2005, p.46-47

Please be aware that the free essay that you were just reading was not written by us. This essay, and all of the others available to view on the website, were provided to us by students in exchange for services that we offer. This relationship helps our students to get an even better deal while also contributing to the biggest free essay resource in the UK!