Fairly Priced Deposit Insurance, Incentive Compatible Regulations and Bank Asset Choices
THE GENEVA PAPERS ON RISK AND INSURANCE THEORY, Vol. 21 No. 1, June 1996
Posted: 13 May 1998
This paper provides incentive compatible regulations that support fairly priced deposit insurance in a competitive banking industry. If informational asymmetry exists between the regulator and banks regarding loan quality, but the regulator can observe actual loan rates charged, then imposing a capital requirement schedule that leads market loan rates to decrease in loan quality is shown to be incentive compatible. Competition in the loan market induces banks to be indifferent to all loans that satisfy a minimum acceptable quality and reject all riskier loans. The regulator could reduce the banking industry's riskiness by imposing stricter capital requirements that increase this minimum quality.
JEL Classification: G21
Suggested Citation: Suggested Citation