Working Paper: NBER ID: w22223
Authors: Charles W. Calomiris; Matthew Jaremski
Abstract: Economic theories posit that bank liability insurance is designed as serving the public interest by mitigating systemic risk in the banking system through liquidity risk reduction. Political theories see liability insurance as serving the private interests of banks, bank borrowers, and depositors, potentially at the expense of the public interest. Empirical evidence – both historical and contemporary – supports the private-interest approach as liability insurance generally has been associated with increases, rather than decreases, in systemic risk. Exceptions to this rule are rare, and reflect design features that prevent moral hazard and adverse selection. Prudential regulation of insured banks has generally not been a very effective tool in limiting the systemic risk increases associated with liability insurance. This likely reflects purposeful failures in regulation; if liability insurance is motivated by private interests, then there would be little point to removing the subsidies it creates through strict regulation. That same logic explains why more effective policies for addressing systemic risk are not employed in place of liability insurance. The politics of liability insurance also should not be construed narrowly to encompass only the vested interests of bankers. Indeed, in many countries, it has been installed as a pass-through subsidy targeted to particular classes of bank borrowers.
Keywords: Deposit Insurance; Systemic Risk; Banking Regulation
JEL Codes: E44; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deposit insurance (G28) | increase in systemic risk (F65) |
| moral hazard (G52) | increase in systemic risk (F65) |
| adverse selection (D82) | increase in systemic risk (F65) |
| deposit insurance (G28) | greater risks taken by insured banks (G21) |
| greater risks taken by insured banks (G21) | higher failure rates compared to uninsured banks (G21) |
| political motivations behind deposit insurance (G28) | riskier lending practices (G21) |
| lack of effective prudential regulation (G28) | exploitation of insurance (G52) |
| exploitation of insurance (G52) | increased leverage (G32) |
| increased leverage (G32) | greater likelihood of failure during economic downturns (F65) |