Deposit Insurance vs Lender of Last Resort

Insurance removes the reason to run, but only up to the cap

A run happens because depositors are paid in the order they arrive and the bank cannot pay everyone at once. Insurance breaks that logic by making arrival order irrelevant for covered balances. Suppose the coverage cap is an illustrative $100,000 per depositor per bank, a figure invented here since real caps are set by law and differ by country. A depositor holding $40,000 has no reason to queue at all, because the money is protected whatever happens. A depositor holding $160,000 is covered on $100,000 and has $60,000 genuinely at risk, so that depositor still has every reason to move first. This is why large uninsured balances, typically held by businesses, are the part of the funding base that actually runs. It also explains a standard piece of advice: the same $160,000 split across two insured banks is fully covered, because the cap applies per bank. The design has a well known cost. Once depositors stop monitoring, a bank can take on riskier loans without paying more for funding, so insurance is normally paired with supervision and capital rules. The mechanics of the panic itself are set out at /glossary/bank-run.

Emergency lending fixes timing, and it is deliberately expensive to use

The second backstop works on the bank rather than the depositor, and it addresses /glossary/liquidity-risk rather than losses. Take an illustrative bank holding $10 billion of sound loans and $200 million of reserves that faces $1 billion of withdrawals in a week. It is not insolvent; it simply has $800 million less cash than it needs, since $1 billion minus $200 million is $800 million. Selling loans quickly would mean accepting a discount and turning a timing problem into a real loss. Instead it pledges loans as collateral at the /glossary/discount-window and borrows the $800 million, pays the departing depositors and repays the loan as its assets mature. Nothing was given away. The long standing principle is to lend freely to solvent institutions against good collateral and to charge a penalty rate, so that banks turn to the facility only when private funding has genuinely closed. The penalty is the whole point. Cheap emergency lending would encourage banks to hold fewer liquid assets in the first place, which is the same incentive problem that insurance creates on the other side of the balance sheet.

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