A deposit guarantee scheme is a program enacted to insure deposits against the failure of the institution that holds them. Often, these programs are run by national governments. They are most effective if the government is perceived as a credible entity. Typically, the government guarantees deposits up to a certain level for each account. If a bank closes and cannot repay its depositors, the deposit guarantee program will make up the difference up to the maximum level for each depositor.
Each deposit guarantee scheme is designed to prevent panics inspired by a lack of faith in a nation’s banking system. When a customer deposits funds into a bank account, he is loaning that money to the bank. The bank uses that money to make investments, like issuing loans. The security of the money that the depositor has loaned to the bank depends on the institution’s trustworthiness.
If customers doubt the credibility of the bank in which their money is held, they go to the bank to withdraw those funds. A widespread panic causes many customers to demand withdrawals at the same time, and the requested funds can exceed the amount of reserves the bank is required to have on hand to satisfy deposits. At that point, the bank must liquidate its assets to pay its depositors. If it has too many long-term deposits, however, it cannot liquidate sufficient funds, becomes insolvent and must close.
A deposit guarantee scheme aims to prevent banking panics by bolstering public confidence in the banks. People rush to the banks because they are afraid that only the first ones there will be able to withdraw money. As everyone rushes to be first, the bank runs out of funds. If depositors are confident that their accounts are safe, they do not rush to the bank at the first sign of trouble. Thus, the deposit guarantee scheme's promise of reparation in the case of bank failure is instrumental in preventing that failure from occurring.
In the United States, deposit insurance is provided by the Federal Deposit Insurance Corporation, or the FDIC. It was created in 1933 as part of the Glass-Steagall Act, a reaction to the banking panics that occurred during the Great Depression. The FDIC guarantees up to $250,000 US Dollars (USD) per customer per institution at commercial banks. Banks that are covered by the FDIC post signs informing customers of that coverage, which inspires confidence because it is backed by the credit of the United States government.