Deposit Insurance: Theories and Facts

Abstract

Economic theories posit that bank liability insurance is designed to serve the public interest by mitigating systemic risk in the banking system through the reduction of liquidity risk. Political theories, however, see liability insurance as serving the private interests of banks, bank borrowers, and depositors, potentially at the expense of the public interest. Empirical evidence—both historical and contemporary—supports the private-interest approach, as liability insurance has been associated with increases, rather than decreases, in systemic risk. Exceptions to this rule are rare and reflect design features that prevent moral hazard and adverse selection. Prudential regulation of insured banks has generally not been a very effective tool in limiting the systemic risk increases associated with liability insurance. This likely reflects purposeful failures in regulation; if liability insurance is motivated by private interests, then there would be little point to removing the subsidies it creates through strict regulation. The same logic explains why more effective policies for addressing systemic risk are not employed in place of liability insurance. The politics of liability insurance thus should not be narrowly construed to encompass only the vested interests of bankers. Indeed, in many countries, liability insurance has been installed as a pass-through subsidy targeted to particular classes of bank borrowers.