Risk-based Deposit Insurance: An Incentive Compatible Plan

DEPOSIT INSURANCE PROVIDED by the Federal Deposit Insurance Corporation (FDIC) violates a basic principle of insurance: premiums are not adjusted for bank risk. Thus, banks have the incentive to take on more risk, increasing the insurer's liability but not the banks' costs (see Keeton 1984). This incentive is heightened further by the FDIC's timidity in closing failed banks. If uninsured depositors and other creditors were able and willing to evaluate bank risk and demand risk-adjusted returns on investments, the incentive for risk-taking would be weakened, since, in such a world, deposit insurance could be fairly priced (see Thomson 1987). When asymmetric information concerning both bank risktaking and insurer behavior characterizes the banking market [as Crane (1976); Avery, Belton, and Goldberg (1988); Keeton and Morris (1987); and Brewer and Lee (1986) all suggest to be the case], other remedies must be sought.