Deposit insurance and bank liquidation without commitment: Can we sleep well?

Abstract

This paper assesses the effects of the orderly liquidation of a failing bank and the ex post provision of deposit insurance on the prospect of bank runs. Assuming that the public institutions in charge of these policies lack commitment power, these interventions, both individually and jointly, are chosen and undertaken ex post. The costs of liquidation and redistribution across heterogeneous households play key roles in these decisions. If investment is sufficiently illiquid, a credible liquidation policy will deter runs. Despite the lack of commitment, deposit insurance, funded by an ex post tax scheme, will be provided unless it requires a (socially) undesirable redistribution of consumption that outweighs insurance gains. If taxes are set optimally ex post, runs are prevented by deposit insurance without costly liquidation. If not, a combination of the two policies will prevent runs.