The March 2023 US banking turmoil in the featured:
1. Unusually fast depositor withdrawals
2. Bankruns on a small share of the regulated banking sector
3. Ex-post coverage of all ex-ante uninsured depositors under the fear of ”systemic contagion”.
These events triggered a debate on deposit insurance reform. To contribute to this debate, this paper extends the existing work on banking crises and deposit insurance along two dimensions: a) panics are idiosyncratic and emerge as a unique equilibrium outcome b) failure of a share of banks leads to a dynamic contagion to non-defaulting banks and real economic activity. The model is calibrated to the US economy and used to assess FDIC’s reform proposals. Three novel results emerge. First, increasing deposit insurance in times of distress is effective at preventing liquidity crises and containing moral hazard. Second, if bank-runs are faster than the government, ex-post increases in deposit insurance cannot prevent liquidity crises but can mitigate them. Mitigation gains are small which suggests that ex-ante deposit insurance increases are preferred to ex-post extensions. Third, even under fast bankruns, the optimal ex-ante deposit insurance limit is around 65 % of total deposits, about 10 percentage points higher than current US policy. Therefore, fast bank-runs do not justify full deposit insurance.
We examine the effects of tighter capital requirements in a quantitative model with banks exposed
to solvency risk and foreign liabilities. Setting bank capital requirements at appropriately high levels is essential to enhance the resilience of banks against sudden losses and the risk of insolvency. However, a reduction in bank solvency risk in turn also helps banks to increase their reliance on foreign liabilities, leading to a novel trade-off of bank capital regulation in open economies.
Higher capital requirements make banks, and the economy as a whole, more resilient to shocks originating in the banking sector, while at the same time increasing their exposure to a sudden reduction in banks’ availability of foreign funds.
Our results suggest that in the presence of bank solvency risk, foreign exchange rate interventions are complementary to bank capital requirements in addressing financial vulnerabilities. Estimates using bank-level data on Peru’s transition to higher capital requirements lend support to the foreign liability channel of bank capital requirements.