Is Deposit Insurance a Good

Thing, and if so, Who should

pay for it?
Alan Morrison,
Merton College & Saïd Business School, Oxford
Lucy White,
Harvard Business School & FAME, Université de
Lausanne
 Why do we have deposit
insurance?
• Deposit Insurance Schemes
increasingly adopted around the
world.
• Yet empirically they are associated
with increasing the probability of a
banking crisis.
• So why are they adopted?
 Literature on Deposit
Insurance
• Large literature (starting with Merton 1977) looks
at how to price deposit insurance fairly.
• Small literature considers that this may not be
possible (Chan et al 1992) or desirable (Frexias
and Rochet 1998).
• These papers all take the existence of deposit
insurance as given.
• Closest in Spirit: Diamond and Dybvig (1983) and
Matutes and Vives (1996). These papers provide a
rationale for deposit insurance.
 Rationales for Deposit
Insurance
• Diamond and Dybvig (1983): deposit insurance
rules out a bad sun spot equilibrium where all
depositors run.
• Matutes and Vives (1996) deposit insurance
reduces vertical differentiation and increases
bank competition: may be good or bad.
• We abstract from both of these. In our model, we
show that deposit insurance can be a useful
subsidy to the banking system that reduces moral
hazard.
• Basic intuition: a subsidised deposit insurance
scheme increases rents for successful bankers.
 The Model
• N risk-neutral consumers per country, with $1 and CRS
project:
– Returns R if successful (probability pL)
– 0 otherwise
• Each country has  bankers with $1 and a CRS project
• A proportion g of bankers is sound; the rest are unsound
• Sound bankers have a monitoring technology which at cost C
per dollar increases the success probability to pH=pL+p
• Banker type is unobservable: Adverse Selection problem
• Monitoring is unobservable: Moral Hazard problem
 Banks
• A bank is a banker who takes depositor funds to
augment the size of his project
• Since bank investments are weakly more profitable
than consumers, (utilitarian) welfare is maximised if
consumers deposit in banks.
• Banks receive fee Q from depositors (deposit rate =
R-Q)
– Return to size k bank is therefore R+(k-1)Q
Ck  Rp
• Monitoring is efficient: Rp>C Q
k  1p
• …but must be incentive compatible (MIC):
…and also better than the outside option (BIC): Q  C p H
• Depositing IR constraint (DIR): Q  gRp  g 
– Where (g)=pL+gp is unconditional prob of
investment success.
 Banking without Deposit
Q
Insurance
MIC
gRp
pL  gp UDIR

C BIC
pH
k
k=1 kU

• Banking is possible only if UDIR>BIC: iff g big enough

• The largest possible bank is of size kU.
• But if kU<N+ then not all funds are invested in the
banking system - there is rationing of deposits.
• Deposit insurance will allow us to expand the banking
system.
 What externality does deposit
insurance correct?
• The combination of adverse selection and
Moral Hazard means that the banking
sector is socially too small.
• MH means that bankers must receive rents
for managing deposits; AS makes
depositors too reluctant to pay such rents:
they may pay a fee and get no monitoring
 banking sector is socially too small.
 A Model with Deposit
Insurance
• Deposit Insurance fund collects lump sum taxes ex
ante from Bankers (B), Depositors (D), and Non-
Depositors (N).
• All proceeds will be paid out ex post to depositors in
failed banks.
• Moral hazard incentive constraint unchanged (both
sides multiplied by (1-B)). Intuition: bank does not get
anything from deposit insurance directly, only
indirectly from what depositors are willing to pay…
• The DIR constraint is relaxed because (a) depositors
will now receive a payout if the bank fails (b) non-
depositors may be taxed more highly than depositors.
 Deposit Insurance as a Way to
Encourage Depositing
• Thus, intuitively, deposit insurance raises the
depositors’ IR constraint and increases the level of
bank deposits.
• Complete deposit insurance is not optimal as then banks
could expand without bound – the MIC would be
violated but depositors would not care.
• The optimal scheme ensures that all funds are invested
in the banking sector, and can be implemented in a
number of ways, for example:
 B= D =N a flat rate tax
 B= D =0; N >0 through general taxation, constituting a
net subsidy to the banking system.
 Intuition
• Taxation of bankers is welfare neutral:
– It reduces their incentives to monitor by
reducing their capital
– BUT it raises their incentives to monitor by
increasing what they can extract from
depositors.
• These two considerations exactly offset.
• Similarly, taxing depositors ex ante to provide
them with a subsidy ex post has no effect on
deposits when depositors are risk neutral.
• Thus only a general subsidy to the banking
system through N has a beneficial effect.
 Bank Size with Deposit
Insurance
Q Banking Sector
With
Banking sector without deposit MIC Deposit Insurance
QN RDIR (D,N, g)
insurance
QS RDIR (D,N,g)

k=1 k*(g) k**(g)=N+ k

• Welfare effect of increasing deposit

insurance up to the optimum level.
 Robustness Checks
• We consider how the deposit insurance
fund should be invested: in the banking
system or in a less productive storage
technology (T-bills).
• We consider whether the taxation for
deposit insurance should be raised ex ante
or ex post.
• We consider whether the adverse selection
problem could be countered using capital
requirements, cross subsidies or
coinsurance schemes.
 Comparative Statics
• Level of Deposit Insurance should be
larger the worse is the quality of the
banking sector (given that it is still more
productive than depositors’ outside option).
• Low banking sector quality also associated
with higher probability of financial crisis.
• Shows that deposit insurance can be a good
idea despite its empirical association with
poor outcomes.
 Conclusions
• A new rationale for deposit insurance.
• Previous literature has considered that
deposit insurance should be “fairly priced”.
• We show that if the banking sector
exhibits both adverse selection and moral
hazard, economic productivity can be
enhanced by a net subsidy to the system
which can take the form of deposit
insurance.