Designing an Efficient and Incentive Compatible Government-Provided Deposit Insurance Program for Developing and Transitional Economies

Abstract

This paper reviews the causes of recent banking crises, particularly in the United States. The paper argues that to the extent banks are perceived to be special, it is primarily because of poorly designed special public policies, particularly safety nets, rather than their inherent characteristics. These flaws have contributed to the costly recent banking crises in most countries of the world. As a result, preventing future crises centers on correcting the flaws in these policies. The U.S. reformed its government-provided deposit insurance structure in the Federal Deposit Insurance and Corporation Improvement Act (FDICIA) of 1991 to reduce the moral hazard problem of banks and the agency problem of regulators. The reform focuses on imposing regulatory discipline that mimics the discipline the market imposes on firms not subject to a safety net and on resolving a troubled bank before its economic capital is negative. If successful, this would impose losses only on shareholders and make deposit insurance effectively redundant. Aspects of this new structure appear to be appropriate for other countries.