Funding deposit insurance

Abstract

We present a quantitative model of deposit insurance to characterize the optimal levels of coverage for depositors and premiums raised from banks. Premiums contribute to a deposit insurance fund that lowers taxpayers’ resolution cost of bank failures. The key model tension is the policymaker’s dynamic tradeoff between building a fund to discourage moral hazard and insulate taxpayers from large fiscal shortfalls, and allowing banks to productively invest their deposits. We find that risk-adjusted premiums reduce moral hazard, enabling the policymaker to increase the share of covered deposits to total deposits by 12.5 percentage points and decrease the share of expected annual bank failures from 0.74% to 0.60%. The model predicts a fund-to-covered-deposits ratio that matches the data and declines in taxpayers’ income due to taxpayers’ risk aversion.