Market-oriented interest rate, deposit insurance system and bank runs

Abstract

PurposeIn the transitional process of promoting market-oriented interest rate, China is confronted with an important theoretical and practical issue: how to avoid bank runs and realize the smooth operation of the financial system. The purpose of this paper is to construct a bank-run dynamic model by taking into account a market environment with the transmission of multiple rounds of noise information, a comprehensive consideration of depositors’ expectation of return on assets (or earning rate/yields of assets), the efficiency of information processing and dissemination, and the different motives for premature withdrawal.Design/methodology/approachThe authors discussed the dynamic process of bank runs, furnished the ratio and number of each round of bank run, and characterized the corresponding dynamic equilibrium as well. Furthermore, the authors expanded the benchmark model by incorporating the deposit insurance system (DIS) to discuss the action mechanism of DIS overruns.FindingsThe results show that DIS implementation has two opposite effects: stabilized expectation and moral hazard, by virtue of its influence over the two types of premature withdrawal motives of depositors; the implementation effect of DIS rests with the dual-effect comparison, which is endogenous to the institutional environment.Originality/valueThe policy implications are as follows: while implementing DIS, it is necessary to establish and improve the corresponding institutional construction and supporting measures, to consolidate market discipline and improve the supervisory role of the bank’s internal governance mechanism, so as to reduce the potential moral hazards. The financial system reform shall be furthered and the processing and dissemination efficiency of information be elevated to prompt depositors to form stable withdrawal expectations, thereby enhancing the stabilizing effect of DIS.