Partial deposit insurance and moral hazard in banking

Abstract

Purpose

The purpose of this paper is to study the optimal coverage limit in a model of deposit insurance with capital requirements and risk sensitive premia to prevent moral hazard.

Design/methodology/approach

The theoretical model has incorporated capital requirements, risk‐sensitive premium, and partial deposit insurance in a partial equilibrium model. The model discusses the interaction among risk‐taking banks, ex‐ante heterogeneous depositors, and a deposit insurer.

Findings

First, the paper shows that optimal coverage encourages depositors' monitoring and withdrawals. Partial deposit insurance improves social welfare. Second, risk‐sensitive premia and market discipline are essential to reduce bank risk taking behavior. Third, adjustment between level of coverage and the premium guarantees long term liquidity of the deposit insurance funds and makes banks better off. Fourth, numerical findings are consistent with the empirical evidence that shows differences in coverage between countries.

Research limitations/implications

Timing and frequency of adjustments to coverage limits and the implementation of co‐insurance have been beyond the scope of this study but those implications are worth further investigation.

Originality/value

In the current crisis, banking regulations combined with poor management and supervision have been responsible for banks' improper leverages, lending and securitization. A bank failure could easily turn into a crisis when the financial institution is overly exposed to credit risks and when the government is least equipped to deal with those risks. Thus, the study of the partial deposit insurance is important in achieving stability in the banking sector.

Citation

Gan, L. and Wang, G.W.Y. (2013), "Partial deposit insurance and moral hazard in banking", International Journal of Commerce and Management, Vol. 23 No. 1, pp. 8-23. https://doi.org/10.1108/10569211311301411