Is Deposit Insurance a Good Thing, and if so, Who should pay for it? - PowerPoint PPT Presentation

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Is Deposit Insurance a Good Thing, and if so, Who should pay for it?

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... insurance rules out a bad sun spot equilibrium where all depositors run. ... Return to size k bank is therefore R (k-1)Q. Monitoring is efficient: R p C ... – PowerPoint PPT presentation

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Title: Is Deposit Insurance a Good Thing, and if so, Who should pay for it?


1
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

2
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?

3
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.

4
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.

5
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 pHpL?p
  • Banker type is unobservable Adverse Selection
    problem
  • Monitoring is unobservable Moral Hazard problem

6
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
  • Monitoring is efficient R?pgtC
  • but must be incentive compatible (MIC)
  • and also better than the outside option (BIC)
  • Depositing IR constraint (DIR)
  • Where ?(g)pLg?p is unconditional prob of
    investment success.

7
Banking without Deposit Insurance
Q
MIC
UDIR
BIC
k
k1
kU
  • Banking is possible only if UDIRgtBIC iff g big
    enough
  • The largest possible bank is of size kU.
  • But if ?kUltN? 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.

8
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.

9
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.

10
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 gt0 through general taxation,
    constituting a net subsidy to the banking system.

11
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.

12
Bank Size with Deposit Insurance
Banking Sector With Deposit Insurance
Q
MIC
Banking sector without deposit insurance
QN
RDIR (?D,?N, g)
QS
RDIR (?D,?N,g)
k
k(g)N?
k(g)
k1
  • Welfare effect of increasing deposit insurance up
    to the optimum level.

13
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.

14
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.

15
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.
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