Protecting Depositors
Much regulation in credit markets is directed toward the relationship between a lender and the ultimate owners of the funds that are lent, depositors
in many cases. Indeed, creating an environment in which savings can be mobilized in the form of deposits is an essential part of operating an efficient credit market. Depositors typically are concerned about the safety of their deposits
as well as the return that those deposits yield.
Providing reliable receptors of savings in rural areas -of developing countries
may seem especially problematical because of the covariant risk discussed earlier. Particular problems arise if all depositors wish to retrieve their savings at
the same time, which may lead to bank runs. This problem is compounded if
the withdrawals occur when borrowers are having difficulty repaying their
loans. In such situations market segmentation becomes particularly costly if it
prevents funds from flowing toward regions where demands for retrieving deposits are greatest. The farm credit program in the United States, established
with such issues in mind, provides a clearinghouse for funds to flow between
regions. The program was necessitated, however, by restrictive legislation that
disallowed branch banking in favor of unit banking, a kind of legislated segmentation of the credit market.
The economics literature studies cases in which depositors withdraw funds
en masse, causing the bank to collapse. Two different views emerge on the efficiency of such situations. In Diamond and Dybvig's (1983) analysis, bank runs
are inefficient. They are modeled as resulting from a loss of confidence. Once
depositors lose confidence, a run becomes a self-fulfilling prophecy, because if
depositors expect others to withdraw funds in a hurry, it is rational to follow
suit, for fear that the bank will be bankrupt if they wait. The result is a cascading collapse of the bank. Such losses of confidence need not have anything to do with a fundamental change in the economy. The whims of depositors are
enough to lead to collapse