Risk-shifting incentives of depository institutions: A new perspective on federal deposit insurance reform

Abstract

We characterize the risk-shifting incentives of a depository institution as arising fundamentally from the existence of limited liability and the associated convex payoff to equity-holders. This risk incentive feature is unchanged by deposits being insured, and hence excessive risk-taking by depository institutions is not solely attributable to the flat rate insurance premium. Consequently, the incentive problem cannot be resolved through a risk-based insurance premium, contrary to the prevailing view. We propose a solution that eliminates risk-shifting through an optimal tax structure and specify a corresponding insurance premium that is revenue neutral from the social planner's (regulator's) standpoint. The solution is derived in the context of a social objective function that trades off the benefits of liquidity services by banks and the unique informational role of bank loans with the costs of investment distortions engendered by risk-shifting.