A very interesting, and well-thought-through, analysis by the RBA's Grant Turner, who comments:
An essential feature of a well-functioning financial system is its ability to channel funds from savers to borrowers. Banks and other deposit-taking institutions provide this function by accepting deposits and issuing debt into capital markets, and then lending these funds on to borrowers, typically at longer maturities. For this process of financial intermediation to work effectively, depositors and other creditors need to have a sufficient degree of confidence that their funds are safe. In the absence of depositor confidence, there is a heightened risk of deposit runs and contagion to other institutions given the limited scope for most depositors to differentiate between safe and unsafe banks. Confidence in the banking system is therefore important for financial system stability and, to this end, governments and regulatory authorities put in place various legal and regulatory arrangements to support confidence among bank creditors that their funds are secure.
There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.
