Informal Financial Arrangements and the Stability of Deposit Insurance in Less Developed Countries

Abstract

Deposit insurance first appeared in the State of New York in 1829 to guarantee banknotes and deposits. A number of other states quickly established similar schemes. Some of these schemes were short-lived, as their true cost became known in the panic of 1837, while others were terminated only after the Federal government instituted taxes on banknotes, thereby effectively eliminating all competitors in the currency creation market.' After the Knickerbocker Trust panic of 1907, there was renewed interest in deposit insurance, but only limited adoption. The great depression during the 1930s led to the current system, which is mandatory for banks that are members of the Federal Reserve System and voluntary for some state-chartered banks.2 A formalized deposit insurance system like that in the U.S. is found in only a small number of other countries, with varying degrees of coverage and membership requirements.3 Significant omissions include Panama and Hong Kong, who have large banking sectors in their economies. Accordingly, the role of deposit insurance in the growth of financial intermediaries is fairly ambiguous. One reason that deposit insurance plays a smaller role in developing countries is that they typically suffer from a less diversified economic base, making them more prone to liquidity crises that deposit insurance cannot prevent. Informal financial arrangements, such as savings clubs and rotating credit associations, may be more effective in providing credit than banks or other financial intermediaries, primarily because they do not provide demand deposit accounts and other banking services that may lead to an immediate withdrawal of funds. Informal arrangements often provide for direct renegotiating between borrower and lender. The ability to renegotiate directly with a borrower, not using a bank as an intermediary, provides more liquidity for the lender than a bank offers under similar circumstances because banks must consider the claims of all other