Deposit insurance and risk taking

We review the theory of deposit insurance, highlighting the underlying assumptions that were not satisfied during the recent financial crisis and that may have led to serious policy mistakes. In theoretical models, deposit insurance is mostly seen as an equilibrium selection device to avoid panic-based runs. In such a context, it is not drawn on and is thus costless and fully credible. However, if bank runs are linked to a fall in asset values, providing deposit insurance can be very costly and, as the case of Ireland has shown, can even threaten sovereign solvency. This perspective indicates a need for new research on the relation between bank failures, deposit insurance schemes, sovereign default, and currency depreciation, and for reforms of deposit insurance schemes. Copyright 2011, Oxford University Press.