Deposit Insurance, Capital Requirements, and Financial Stability

Abstract

This paper assesses the effects of insurance and capital requirements on assets' equilibrium returns in a capital-asset-pricing model in which intermediaries possess better information than the public about the yields on a set of assets. Equilibrium returns depend on two risk premiums that intermediaries incur on their liabilities: an explicit premium that reflects the public's view of the risks inherent in intermediaries' assets and an implicit premium that reflects intermediaries' risk of losing a share of their rent by leveraging their capital. Insurance reduces intermediaries' cost of funds, thereby reducing risk premiums on assets and stabilizing equilibrium returns when the public's assessment of yields changes. Because fair insurance premiums typically are small compared to intermediaries' own implicit premiums, any subsidy that low insurance premiums might confer does not induce intermediaries to increase their leverage excessively. Greater capital requirements increase intermediaries' implicit risk premium and diminish their capacity to stabilize equilibrium returns. When the yields of assets fall significantly, both insurance and capital requirements can precipitate disintermediation abruptly. This disintermediation can occur most frequently when intermediaries must maintain their scale of operations in order to earn their rent. Because financial stability ultimately depends on the stability of returns on capital goods, macroeconomic policy ultimately underwrites the lower cost of capital promised by insurance and the security promised by capital requirements.

Does Corporate Governance Matter in Deposit Insurance? DI and Moral Hazard in Joint Stock and Mutual Financial Intermediaries

“…Our focus is on the third. It is widely known that the presence of deposit insurance encourages JSB shareholders to take even more risk (see Kopcke,[18]; Milhaupt, [22]; Brewer, [2]; Carr et al [4]; Brewer and Mondschean, [3]; Dreyfus et al [6]; Hassan et al, [10]; Keeley, [15] to mention just a few), and this incentive increases as the …nancial situation of the bank deteriorates in what is known as "gambling for survival". Again, this gambling for survival is related to the "option-like" property of the deposit insurance and bank shares (Flood,[8]; Merton [21]).…”

“…This result can be found by setting ® = 0 in equation (14) and adjusting the appropriate rates from a F C rate to a J SB rate. Nonetheless, to check results, we derived equation (18) using the same methodology as for the F C . 2 7 We can also express the relationship as…”

“…To further our understanding of the possible range of MH values (positive or negative), simulations were performed using equation (14) and (18), by assuming distributions for each of the variables of the MH i ; i = F C; JSB. From these simulations, we obtain a distribution of MH i skewed to the right and positive on all its domain which is in line with the analysis presented above.…”

The Influence of Deposits Insurance on the Stability of the Baltic States Banking System / Indėlių Draudimo Įtaka Baltijos Šalių Bankų Sistemos Stabilumui

“…Due to these reasons the world nancial markets and changes in them manifested through globalization processes and in uencing the stability of the nancial system of a country have become the object of scienti c research during the last decade. The importance of nancial crises and their in uence on the economies of the countries, stability of the nancial sector, highlighting the role of banks, is proved by scienti c research not only in the world (Drehmann 2002;Hoque 2009;Laeven, Valencia 2008;Ingves, Lind 1996;Ucal et al 2010;Dahlheim, Nedersjo 1993;Viotti 2000, Maysami, Lim 2004Sabourin 2007;Kopcke 2000), but also in Lithuania (Strumickas, Valanciene 2006;Macerinskiene, Ivaskeviciute 2008;Martinaityte 2008;Leika 2008;Lakstutiene, 2008, Lakstutiene et al 2006Bogu-slauskas, Mileris 2009;Zukauskas, Neverauskas 2008). Such research does not speak about the nancial security net which is necessary to reduce the risk of nancial crises.…”