Three paradigms for the role of capitalization requirements in insured financial institutions

Abstract

Standard models for deposit insurance strike analogies to more familiar financial contracts and conceive of risk as exogenous. The oldest model of deposit insurance likens it to passively underwriting casualty insurance. A more sophisticated, but still bilateral model likens deposit insurance to writing a passive put option on the enterprise whose funding is insured. Delays in acknowledging the wreck of the S&L industry and its federal insurer (FSLIC) discredit these models as guides to managing a deposit-insurance fund. Deposit insurance is better interpreted as a trilateral performance bond that enhances the credit of an insured institution. This interpretation endogenizes risk, emphasizes incentive conflict, and underscores the need to optimize loss-control activity. The bonding model clarifies that a subset of the monitoring and disciplinary activities traditionally undertaken by government officials can usefully be privatized.