Evaluating the Relative Effectiveness of Deposit Insurance and Capital Requirements in Restraining Risk Taking in Banking

Abstract

There are two regulatory polices as major financial system safety nets, deposit insurance and capital requirements. By using financial intermediary model, we evaluate relative effectiveness of these regulatory policies in restraining bank's risk taking. For each of them, there are two types of regulatory policy, flat and risk-based. In our study, we confirm risk-based regulatory policies are better than flat type one. Secondly, in evaluating relative effectiveness of restraining risk taking, there are two major forces working together, marginal benefit and marginal cost in taking risk. When marginal benefit in risk taking is greater than marginal cost in taking risk, risk-based deposit insurance premium is more effective than risk-based capital requirements in containing risk-taking incentives; otherwise, risk-based capital requirement is more effective. We conclude that proper regulatory policy combination should take these marginal benefits and costs of bank risk taking into safety net design consideration in order to prevent financial system fragility.