The Effect of Implicit Deposit Insurance on Banks Portfolio Choices with an Application to International 'Overexposure'
We analyze the impact of ongoing FDIC deposit insurance practices on how banks price risk. We show that FDIC insurance generally subsidizes risky loans, and that the subsidy increases with risk. We also show that the FDIC subsidy increases if contractually uninsured deposits are insured implicitly. Implicit insurance has the perverse effect of biasing the subsidy towards loans that represent systemic risk to the banking system and may entail a tax to loans with no systemic risk. This analysis can help explain what appeared to be systematic underpricing of LDC loan risks, prior to the debt crisis.
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