The relationship present between a financial institution and that of the deposits it receives from its clients can be seen similar to that of a marriage agreement. One simply cannot work without the other.
As we economists know, financial intermediaries make their profits through the deposits that are made.
It’s a simple marriage agreement you see.
Let us observe from a very simple perspective; a couple meets, courts and falls in love, subsequently both commit to each other and unify themselves in the form of holy matrimony. This union yields the birth of an offspring or two (loans, investments), their offspring are cared and nurtured for as private investment until they are old enough to bear fruit of hard labor and become a mutual return of investment to the union of both man and woman (in this case profit), man and woman live happily ever after till death do them part.
Quite a fairy tale ending wouldn’t you agree? However, that is not usually how these interactions work.
In reality the tango which occurs between financial intermediaries and deposits made by clients is not as simple. Yes—both agree on how deposits and transactions must be carried out. Yes— both want the best return on their investment; both want a stable relationship where fruition with respect to investment is in the interest of both parties; and finally, yes—both parties would rather they not have to look far for their continual existence as a single entity. As you can see, a financial intermediary bases somewhat of its existence on the deposits it receives as this gives it transaction capabilities. Similarly, depositors require financial intermediaries as a secure way of handling their wealth with a sense of security.
But as in the most classic of love stories, questions such as the following persist, “is this the real deal?”, “what if?”, and just like that before any matrimonial bliss is entered, both parties have to be assured that their interests going in are rightfully protected. In this case, I talk of the importance of a pre-nuptial agreement (‘Pre-Nup’) as deposit insurance. You would literally not want to give your life to someone without some sort of back-up or collateral just in case of a defunct. This is why the importance of a deposit insurance cannot be downplayed. A deposit insurance gives both parties a safety net; in both instances the financial intermediary will be able to pay off its depositors; as a result, depositors will not be left without any form of compensation in case of a defunct by any financial intermediary due to a bad investment.
So the question is, why is there mutual love between these two? Deposit insurance—that’s why. No one goes into any contractual agreement in this day and age without some sort of collateral.