Bank depositors in the United States are all financially protected

Govt insures bank deposits.

Economist: This insurance is partly responsible for the high rate of bank failures (there are other reasons too),
Depositors have no financial incentive to find out whether the bank that holds their money is secure against failure. If depositors were more selective, then banks would need to be secure in order to compete for business.

The economist says that this guarantee given by the Govt is making the depositors lax and that is partly responsible for bank failures because banks are becoming lax.

What weakens his argument that Govt's insurance is causing bank failures?

(A) Before the government started to insure depositors against bank failure, there was a lower rate of bank failure than there is now.

It strengthens the economist's argument.

(B) When the government did not insure deposits, frequent bank failures occurred as a result of depositors' fears of losing money in bank failures.

Correct. If frequent bank failures occurred because of depositor's fear of losing deposits (in this fear they perhaps withdrew at critical times), then Govt's insurance helps take care of this factor. It helps avoid bank failures. Not having Govt's insurance will lead to frequent bank failures. Hence, Govt's insurance is not the reason for bank failures. Note that having Govt's insurance may lead to depositors oversight but without it, the depositors are extremely iffy and that leads to 'frequent' bank failures. So Govt's insurance overall has a positive impact in avoiding bank failures.

(C) Surveys show that a significant proportion of depositors are aware that their deposits are insured by the government.

Agrees with the economist's argument. Depositors are aware and hence don't care much.

(D) There is an upper limit on the amount of an individual's deposit that the government will insure, but very few individuals' deposits exceed this limit.

Again, agrees with the economist's argument. Since people's deposits do not exceed the limit, they feel safe.

(E) The security of a bank against failure depends on the percentage of its assets that are loaned out and also on how much risk its loans involve.

Irrelevant.

Answer (B)