What does a guarantee mean?

By Buttonwood

DEPOSIT insurance schemes were a product of the 1930s, when the loss of confidence of savers caused the collapse of many small American banks, worsening the Great Depression. The practice became widespread from the 1970s onwards, with the number of countries using such schemes rising from 12 to 88 between 1974 and 2003, according to an IMF paper.

The argument for deposit insurance is that banks are inherently unstable, by virtue of their economic function; they borrow money in the form of deposits (which can be instantly withdrawn) and lend to businesses on a longer-term basis. They are thus vulnerable to destabilising and self-fulfilling bank runs. But the counter-argument is that of moral hazard; depositors have no incentive to choose between banks on grounds of riskiness, and bank executives can take risks knowing that they are underwritten by the insurance scheme.