Is Deposit Insurance a Good Idea, and if so, Who Should Pay for it?
Description
Joint work with Alan Morrison, Saïd Business School, Oxford.
Deposit insurance schemes are becoming increasingly popular around the world and yet there is little understanding of how they should be designed and what their consequences are. In this model we provide a new rationale for the provision of deposit insurance. We analyse a model in which depositors choose between placing their funds with banks and self-managing them. Bankers have valuable but costly project management skills and the banking sector exhibits both adverse selection and moral hazard. Depositors fail fully to account for the social benefits which accrue from bank management of projects and as a consequence there is under-depositing. The regulator can correct this market failure by providing deposit insurance. Contrary to received opinion, we find that deposit insurance should be funded not by bankers or depositors but through general taxation.
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