A research of deposit insurance mechanism overcoming moral hazard

Abstract

Though the deposit insurance system increases the stability of banking system by averting bank-runs, but it increases the instability of banking system instead because the depositors reduce the market discipline on the bank and the bank has the incentive of risk-taking excessively, this is so-called moral hazard. This paper designs an optimal deposit insurance mechanism overcoming the bank's moral hazard by utilizing the theory and methodology of mechanism designing. The study shows that there exists an optimal deposit insurance mechanism satisfying the incentive compatible conditions to overcome the bank's moral hazard in the deposit insurance market with asymmetrical information, however, compared to the deposit insurance mechanism under symmetrical information, both the deposit insurance coverage and the deposit insurance premium rate decrease.