Show how the existence of deposit insurance creates a moral hazard problem.
The idea
Deposit insurance, funded by bank premiums and ultimately backed by the government, repays depositors up to a limit if the bank fails. Moral hazard arises when protection from the consequences of risk leads to more risk taking. Insured depositors have no reason to monitor the bank or to demand a higher rate from a risky one, so market discipline weakens. Shareholders then hold something like a call option on the bank's assets. They keep the upside of risky bets, while losses beyond their equity fall on depositors and therefore on the insurer. Raising asset risk raises both the equity value and the insurer's expected loss. Remedies include risk-based premiums, minimum capital requirements, supervision, and coverage caps or coinsurance that leave large depositors exposed. A flat premium makes the problem worse. Exam point: moral hazard is the change in behaviour after coverage. Adverse selection is the tendency of risky banks to be the keenest to join.
A practice question
Which feature is designed to reduce the moral hazard created by deposit insurance?
- A flat premium per unit of insured deposits paid equally by all banks.Why not: A flat premium gives no incentive to limit risk.
- Raising the coverage limit so that deposits of any size are insured.Why not: Wider coverage reduces monitoring even more.
- Premiums that rise with the riskiness of the bank's assets. - correct
- Allowing insured banks to hold less capital because depositors are protected.Why not: Lower capital leaves less equity at risk and increases moral hazard.
Risk-based premiums make risk taking costly to the bank. Flat premiums, unlimited coverage and lower capital all weaken incentives.
A harder one
Which situation is an example of moral hazard, as opposed to adverse selection, in deposit insurance?
- Before coverage exists, the riskiest banks are the keenest to join the insurance scheme.Why not: This is adverse selection: the risky self-select into the scheme.
- After coverage begins, a bank shifts assets toward high-yield, high-risk loans. - correct
- Depositors rush to withdraw from a bank after a rumour of losses.Why not: This is a bank run, not a change in behaviour caused by protection.
- The insurer mis-sets premiums because it lacks data on the quality of bank assets.Why not: This is an information problem for the insurer, not a behavioural response by the insured.
Moral hazard arises after the contract is in place, when the protected party changes its behaviour. Self-selection of risky banks into the scheme is adverse selection.
The hardest tier
A bank has USD 900 million of insured deposits and USD 1,000 million of assets. It can invest in a safe project returning USD 1,050 million for certain, or a risky project returning USD 1,300 million or USD 800 million with equal probability. Equity holders get what remains after deposits are repaid (nothing if assets fall short) and the insurer covers any shortfall. Which statement is correct?
- Shareholders prefer the safe project, because both projects have the same expected asset value of USD 1,050 million and the safe one has no risk.Why not: Ignores limited liability: equity receives nothing in the bad state, so equal expected assets do not mean equal equity value.
- Shareholders prefer the risky project: expected equity payoff USD 200 million against 150, and the insurer's expected loss is USD 50 million. - correct
- Shareholders prefer the risky project, and the insurer bears no expected cost because expected assets exceed deposits.Why not: Compares expected assets with deposits; the insurer pays in the bad state, where assets of 800 fall short of 900.
- Shareholders are indifferent: both projects give an expected equity payoff of USD 150 million, because expected assets are equal.Why not: Lets equity go negative in the bad state (-100); limited liability floors it at zero.
Safe project: equity = 1,050 - 900 = 150. Risky project: 0.5 x (1,300 - 900) + 0.5 x 0 = 200. In the bad state assets of 800 are 100 short of deposits, so the insurer's expected loss is 0.5 x 100 = 50. Equity holders gain from risk because their downside is capped.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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