AltInst: Risk-adjusted deposit insurance

"Deposit Insurance, Financial Opening and Risk in a Model of
 Banking Competition"

      BY: TITO CORDELLA
              International Monetary Fund (IMF)
              Universitat Pompeu Fabra
           EDUARDO LEVY YEYATI
              International Monetary Fund (IMF)

Paper ID: CEPR Discussion Paper No. 1939 and IMF Working Paper
           Series 98/97
    Date: July 1998

 Contact: EDUARDO LEVY YEYATI
   Email: Mailto:elevyyeyati@imf.org
  Postal: International Monetary Fund (IMF)
           700 19th Street NW
           Washington, DC 20431 USA
   Phone: (202)623-4395
     Fax: (202)623-6509
 Co-Auth: TITO CORDELLA
   Email: Mailto:tcordella@imf.org
  Postal: International Monetary Fund (IMF)
           700 19th Street NW
           Washington, DC 20431 USA

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ABSTRACT:
 The paper studies the impact of increased competition, arising
 from the relaxation of entry barriers, on the determination of
 interest rates and banks' risk-taking behavior, in a model of
 banking competition for deposits. In a standard environment in
 which public information about banks' risk exposure is limited,
 competition, by reducing bank margins and, in turn, incentives
 to invest in portfolio monitoring, is detrimental to the
 solvency of the system. Moreover, the negative effect of
 competition on portfolio risk is amplified by the existence of
 (explicit or implicit) deposit insurance. However, two
 alternative arrangements (risk-based contributions to the
 insurance fund and public disclosure of financial information)
 are shown to mitigate the negative impact of competition. In
 both, portfolio risk is known, priced and charged to the bank.
 In the first case, by the deposit insurance agency; in the
 second, directly by depositors. This similarity between the two
 alternative arrangements is further illustrated by the fact that
 the equilibrium levels of risk in the case of uninsured but
 fully informed depositors, and in the case of fully insured
 deposits under a risk-based deposit insurance scheme, are the
 same. Moreover, the disciplining effect is maximized in these
 two limiting cases, in which the risk premium is computed over
 the entire portfolio. The final section of the paper explores
 the welfare implications of increasing the deposit insurance
 coverage levels, and relaxing entry barriers, and shows that,
 when risk is fully priced, as in the limiting cases mentioned
 above, both alternative scenarios are welfare superior to the
 benchmark. Indeed, for environments close to these two cases,
 financial opening improves welfare, since the negative impact of
 increased competition on risk becomes negligible.

JEL Classification: D82, G14, G21, G28

Robin Hanson
hanson@econ.berkeley.edu http://hanson.berkeley.edu/
RWJF Health Policy Scholar, Sch. of Public Health 510-643-1884
140 Warren Hall, UC Berkeley, CA 94720-7360 FAX: 510-643-8614

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Received on Fri Oct 23 20:00:58 1998