Abstract
Deposit insurance schemes are increasingly being adopted around the world and yet our understanding of their design and consequences is in its infancy. In this paper we provide a new rationale for the provision of deposit insurance based around the idea that bankers have valuable but costly monitoring skills. The banking sector exhibits both adverse selection and moral hazard and so the social benefits of bank monitoring are shared between depositors and their banks. Therefore too few deposits are made in equilibrium. Deposit insurance can correct this market failure. Contrary to received opinion, we find that deposit insurance should be funded not by bankers or depositors but through general taxation. We also show that the optimal level of deposit insurance should vary inversely with the quality of the banking system.
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