Deposit insurance and reinsurance

Abstract

We study the consequences and optimal design of bank deposit insurance and reinsurance in a general equilibrium setting. The model involves two production sectors, financed by bonds and bank loans, respectively. Financial intermediation by banks is required in the model as we assume that one of the production sectors is risky and requires monitoring by banks. Households fund banks through deposits and equity. Deposits are explicitly insured and banks pay a premium per unit of deposits. Any remaining shortfall is implicitly guaranteed by the government. Two types of equilibria emerge: One type of equilibria supports the Pareto optimal allocation. In the other type, bank lending and the default risk are excessively large. The intuition is as follows: the combination of financial intermediation by banks, limited liability of bank shareholders, and deposit insurance makes deposits risk-free from the individual households’ perspective, although they involve risk from the societal point of view. This distorts investment choices and the resulting input allocation to production sectors. We show, however, that a judicious combination of deposit insurance and reinsurance eliminates all non-optimal equilibrium allocations. Our paper thus may provide a benchmark result for policy proposals advocating deposit insurance cum reinsurance.