Deposit insurance, capital requirements, and financial stability

This paper assesses the effects of insurance and capital requirements on assets' equilibrium returns in a capital-asset-pricing model in which intermediaries possess better information than the public about the yields on a set of assets. Equilibrium returns depend on two risk premiums that intermediaries incur on their liabilities: an explicit premium that reflects the public's view of the risks inherent in intermediaries' assets and an implicit premium that reflects intermediaries' risk of losing a share of their rent by leveraging their capital. Insurance reduces intermediaries' cost of funds, thereby reducing risk premiums on assets and stabilizing equilibrium returns when the public's assessment of yields changes. Because fair insurance premiums typically are small compared to intermediaries' own implicit premiums, any subsidy that low insurance premiums might confer does not induce intermediaries to increase their leverage excessively. Greater capital requirements increase intermediaries' implicit risk premium and diminish their capacity to stabilize equilibrium returns. When the yields of assets fall significantly, both insurance and capital requirements can precipitate disintermediation abruptly. This disintermediation can occur most frequently when intermediaries must maintain their scale of operations in order to earn their rent. Because financial stability ultimately depends on the stability of returns on capital goods, macroeconomic policy ultimately underwrites the lower cost of capital promised by insurance and the security promised by capital requirements.