Optimal Deposit Insurance
66 Pages Posted: 1 Apr 2020
Date Written: February 14, 2020
This paper studies the optimal determination of deposit insurance (DI) when bank runs are possible. In a variety of environments, the welfare impact of changes in the level of deposit insurance coverage exclusively depends on three sufficient statistics: the sensitivity of the likelihood of bank failure with respect to the level of DI, the utility gain induced by preventing the marginal bank failure, which can be expressed in terms of the drop in depositors' consumption, and the direct social cost of intervention in bank failure scenarios, which can be expressed in terms of the probability of bank failure, the marginal cost of public funds, and the mass of partially insured depositors. The same expression applies a) when banks face perfect ex-ante regulation and b) when banks are not allowed to react to policy changes. Under imperfect regulation, because banks do not internalize the fiscal impact of their actions, changes in the behavior of banks induced by varying the level of DI (often referred to as moral hazard) only affect the level of optimal DI directly through a fiscal externality, but not independently. We characterize the wedges that determine the optimal ex-ante regulation, which map to liability-side regulation (e.g., deposit insurance premia) and asset-side regulation. Finally, we explore the quantitative implications of our approach through a direct measurement exercise and a model simulation.
Keywords: Deposit Insurance, Bank Runs, Bank Regulation, Sufficient Statistics
JEL Classification: G21, G28, G01
Suggested Citation: Suggested Citation