Deposit insurance, its problems, and alternatives

Abstract

I conduct a literature review on deposit insurance, its problems, and alternatives. I study how banks create liquidity through fractional reserve banking and how the transformation of maturity implies a risk of bank runs. It is shown that an explicit deposit insurance system can remove the risk of speculative bank runs happening. However, deposit insurance causes problems, especially moral hazard. Literature shows that banks empirically increase risk-taking because of deposit insurance, as theory suggests. To combat this, regulations such as risk-based premia and minimum capital requirements have been proposed and used. Alternative forms of banking, such as narrow banking, are also discussed. However, no proposal provides a completely efficient solution to the issues caused by deposit insurance. Thus, banks can only improve the welfare of consumers by incorporating a risk.