Pablo Herrero, economist | Research

Assessing Options for Deposit Insurance Reform

Author: Pablo Herrero

In March 2023, unusually fast depositor withdrawals led to the failure of several US banks. In response, the government provided an implicit temporary increase in deposit insurance by covering 100 % of the exante uninsured depositors. These events have reignited a debate on deposit insurance reform. This paper contributes to this discussion by developing a dynamic general equilibrium model that  incorporates: (a) idiosyncratic bank failures, (b) contagion from failing banks to solvent banks and the broader economy, and (c) state-contingent deposit insurance. I calibrate the model to US data and use it to assess several options for deposit insurance reform. First, I show that, under fast government response, state-contingent deposit insurance is the optimal policy. Second, if the government’s response is delayed, fixed deposit insurance is preferred to the state-contingent policy. Third, delayed government response does not justify full deposit insurance at all times: the optimal fixed deposit insurance policy covers around 65 % of total deposits.

The Foreign Liability Channel of Bank Capital Requirements

Authors: Luigi Falasconi, Pablo Herrero, Caterina Mendicino, Dominik Supera

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.

The Aggregate Demand Channel of Loan-to-Value Shocks

Authors: Pablo Herrero, Caterina Mendicino, Christopher Carl Schang

We study the aggregate demand channel of LTV contractions and investigate the to what extend monetary policy can counteract aggregate and distributional consequences. We build a general equilibrium heterogeneous agent model with housing and wage frictions that give rise to New Keynesian aggregate demand externalities and confirm a strong aggregate demand channel which has remained unexplored in equilibrium models. We find that accommodating monetary policy can help counteract both the aggregate and distributional consequences of the LTV contraction.