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Will an optimal deposit insurance always increase financial stability?

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  • Drehmann, Mathias

Abstract

In this paper we show that deposit insurance can increase the probability of systemic banking crisis, even though it is optimally designed and its premium is risk related. This is driven by the possibility of contagious bank runs. We prove that contagion only occurs if the correlation between the portfolios of banks is high enough. Without deposit insurance contagious bank runs can impose such great losses on banks, that banks choose less correlated portfolios to avoid contagion altogether. Optimal deposit insurance eliminates this incentive and thus the correlation of portfolios and with it the probability of systemic banking crisis can increase.

Suggested Citation

  • Drehmann, Mathias, 2002. "Will an optimal deposit insurance always increase financial stability?," Bonn Econ Discussion Papers 28/2002, University of Bonn, Bonn Graduate School of Economics (BGSE).
    • Handle: RePEc:zbw:bonedp:282002
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    File URL: https://www.econstor.eu/bitstream/10419/22849/1/bgse28_2002.pdf
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    Cited by:

    1. Sujit Kapadia & Matthias Drehmann & John Elliott & Gabriel Sterne, 2012. "Liquidity Risk, Cash Flow Constraints, and Systemic Feedbacks," NBER Chapters, in: Quantifying Systemic Risk, pages 29-61, National Bureau of Economic Research, Inc.

    More about this item

    Keywords

    Bank runs; contagion; systemic risk; investment of banks; deposit insurance;
    All these keywords.

    JEL classification:

    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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