Deposit insurance and subsidized recapitalizations

Alan D. Morrison and Lucy White

Journal of Banking & Finance, 2011, vol. 35, issue 12, 3400-3416

Abstract: The 2007–2009 financial crisis saw a vast expansion in deposit insurance guarantees around the world and yet our understanding of the design and consequences of deposit insurance schemes is in its infancy. We provide a new rationale for the provision of deposit insurance. In our model the banking sector exhibits both adverse selection and moral hazard, which implies that the social benefits of bank monitoring must for incentive reasons be shared between depositors and banks. Consequently, socially too few deposits are made in equilibrium. Deposit insurance – or, equivalently, bank recapitalization – corrects this market failure. We find that deposit insurance should be funded not by banks or depositors but out of general taxation. The optimal level of deposit insurance varies inversely with the quality of the banking system. Hence, when the soundness of the financial sector is uncertain, governments should consider supporting deposit insurance schemes and undertaking subsidized recapitalizations.

Keywords: Deposit insurance; Bank regulation; Adverse selection; Moral hazard (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2011
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (22)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:35:y:2011:i:12:p:3400-3416

DOI: 10.1016/j.jbankfin.2011.05.017

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