Deposit Insurance and Money Market Freezes

Abstract

In the presence of deposit insurance, a rise in counterparty risk may cause a freeze in interbank money markets. We show this in a general equilibrium model with regionally-segmented bank-based retail financial markets, in which money markets facilitate the reallocation of funds across banks from different regions. Counterparty risk creates an asymmetry between banks in savings-rich regions, which remain marginally financed by the abundant regional insured deposits, and in savings-poor regions, which have to pay large spreads in money markets. This asymmetry distorts the aggregate allocation of credit and, in the presence of demand externalities, can cause large output losses.

Keywords: deposit insurance, money markets, bank solvency, financial market freezes

JEL Classification: E2, E5, G2