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Deposit Insurance, Moral Hazard and the Risk of Runs

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  • Nancy Silva

Abstract

The effectiveness of deposit insurance in eliminating panic runs varies with the size of coverage and the degree of supervisory involvement of the agency in charge of insurance. When the agency is not involved in the supervision of banks, partial insurance preserves the monitoring role of depositors and reduces the region for which runs occur, but it is unable of completely eliminating them. When the agency has a high degree of supervisory involvement, even with partial insurance panic runs disappear as the regulator's signal becomes more precise. However, the smaller the protection offered to depositors, the higher is forbearance. Deposit insurance induces moral hazard by increasing the equilibrium value of the demand deposit contract in the interim period, though this effect seems to be smaller under a broad mandate. Therefore, a scheme where the insurance agency has more supervisory involvement should be preferred.

Suggested Citation

  • Nancy Silva, 2008. "Deposit Insurance, Moral Hazard and the Risk of Runs," Working Papers Central Bank of Chile 474, Central Bank of Chile.
  • Handle: RePEc:chb:bcchwp:474
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    File URL: http://si2.bcentral.cl/public/pdf/documentos-trabajo/pdf/dtbc474.pdf
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    References listed on IDEAS

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    1. Acharya, Viral V. & Yorulmazer, Tanju, 2007. "Too many to fail--An analysis of time-inconsistency in bank closure policies," Journal of Financial Intermediation, Elsevier, vol. 16(1), pages 1-31, January.
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    5. Alonso, Irasema, 1996. "On avoiding bank runs," Journal of Monetary Economics, Elsevier, vol. 37(1), pages 73-87, February.
    6. Chang, Roberto & Velasco, Andres, 2000. "Financial Fragility and the Exchange Rate Regime," Journal of Economic Theory, Elsevier, vol. 92(1), pages 1-34, May.
    7. Acharya, Sankarshan & Dreyfus, Jean-Francois, 1989. " Optimal Bank Reorganization Policies and the Pricing of Federal Deposit Insurance," Journal of Finance, American Finance Association, vol. 44(5), pages 1313-1333, December.
    8. Xavier Freixas, 1999. "Optimal Bail Out Policy, Conditionality and Creative Ambiguity," FMG Discussion Papers dp327, Financial Markets Group.
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    Cited by:

    1. Kiema, Ilkka & Jokivuolle, Esa, 2015. "Why are bank runs sometimes partial?," Research Discussion Papers 10/2015, Bank of Finland.
    2. repec:bof:bofrdp:urn:nbn:fi:bof-201504131153 is not listed on IDEAS

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