Working Paper: CEPR ID: DP4424
Authors: Alan Morrison; Lucy White
Abstract: 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 Paper we provide a new rationale for the provision of deposit insurance. We analyse a model in which agents choose between depositing their funds with banks and placing them in a less productive self-managed project. Bankers have valuable but costly project management skills and the banking sector exhibits both adverse selection and moral hazard. Depositors do not fully account for the social benefits accruing from bank management of projects and therefore too few deposits are made in equilibrium. The regulator can correct this market failure by providing deposit insurance to encourage deposits. Contrary to received opinion, we find that deposit insurance should be funded not by bankers or depositors but through general taxation.
Keywords: Adverse Selection; Banking Systems; Deposit Insurance; Moral Hazard
JEL Codes: D82; E42; E58; G21; G22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Deposit Insurance (G28) | Social Welfare (I38) |
| Funding through General Taxation (H29) | Deposit Insurance (G28) |
| Deposit Insurance (G28) | Encouragement of Deposits (G28) |
| Encouragement of Deposits (G28) | Social Welfare (I38) |
| Quality of Banking System (G21) | Optimal Deposit Insurance (G28) |
| Funding by Bankers or Depositors (G21) | Negative Effects on Deposit Insurance (G28) |