The implications of risk transmission for depositor protection

This paper investigates the nature of risks faced by banks and the ways in which bank regulators seek to protect depositors. We analyse how deposit insurance, the lender of last resort function and other safety net components combine for the protection of depositors. Using a conceptual framework based on modeling deposit insurance as a contingent claim we provide insights into how liquidity risk as well as solvency risk impact the cost of providing deposit insurance. In addition we assess where these risks are transferred if depositors are fully protected from them. Our core finding is that when depositor protection measures are not fairly priced banks have the incentive to take on excessive risk