Deposit Insurance in a Deregulated Environment

Abstract

THE UNITED STATES has had a federal deposit insurance system for half a century. This system has been an unparalleled success in the sense that it has virtually eliminated runs on financial intermediaries. However, the deregulation legislation of 1980 and 1982, as well as the market forces which spawned this legislation, have raised serious questions about the viability of the deposit insurance system as it is currently structured.' There are two basic questions currently at issue. The first is whether the existing system of federal deposit insurance provides an appropriate incentive for risk taking on the part of insured institutions. The second question is whether the current system extends the government's credit guarantee to an inappropriate extent. A number of reforms have recently been proposed to deal with the perceived problems of the current deposit insurance system.2 Most of these reforms, such as risk-adjusted pricing of insurance, represent changes which would tend to compel the federal system to operate as if it were a private insurance market. Indeed, one of the suggested reforms is to replace or supplement the current system with one that is entirely private.3 Most serious observers of the deposit insurance system have taken it for granted that it is necessary to have the government involved in the system, at least as a residual guarantor, in order to provide the credibility necessary to avert runs. In this paper we also take it for granted that some form of government participation in the insurance system is essential.4 The purpose of this paper is to provide some insight into how a deposit