Assessing Options for Deposit Insurance Reform
This paper extends the existing work on banking crises and deposit insurance
Author: Pablo Herrero, Date: August 12, 2024
Abstract
The March 2023 US banking turmoil in the featured:
- Unusually fast depositor withdrawals
- Bankruns on a small share of the regulated banking sector
- 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:
- panics are idiosyncratic and emerge as a unique equilibrium outcome
- 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.