Using efficient bank insolvency resolution to solve the deposit insurance problem

Abstract

Deposit insurance typically suffers from two well-known problems — for banks, moral hazard generated excessive risk taking, and for regulators, poor agency behaviour leading to excessive forbearance. The usual attempts to correct these problems by directly changing the structure of deposit insurance through coinsurance, risk-sensitive premiums, etc, have been largely unsuccessful. This paper proposes an indirect solution that focuses on efficient absolution of insolvent banks before their capital turns negative. If successful, no losses are suffered by insured or uninsured depositors. As a by-product, deposit insurance becomes effectively redundant, but not unnecessary to handle regulations that are not efficient. The paper expands on how to achieve efficient resolutions.