analysis of deposit insurance

in this post we critically examine deposit insurance. We first analyze the underlying problems that motivate a potential need for deposit insurance: asset illiquidity and lack of information concerning the financial condition of households and firms. Then we describe the benefits to society of deposit insurance-and the problem for the deposit insurer.
The Heart of the depository institution problem Depository institution accept deposits that are extremely liquid;that is,no demand, the institution must be prepared to refund, at a one-to-one exchange rate, amounts held in demand deposit and other checkable deposit accounts. the assets that depository institutions acquire are much less liquid. this situation exposes depository institutions to runs, a situation in which many depositors want their funds at the same time and depository institutions are unable to pay them all. because depository institutions expose themselves to such liquidity risks, it is proper to ask why they do so. the answer is that, traditionally, the very nature of the function of depository institutions is to assume this liquidity risk from households and firms-for a fee, of course.
In other words, the ultimate source of the liquidity problem stems from households and firms. Consider a setting in which:
1. households and firms experience liquidity risks.
2. Lacks of information exists concerning the liquidity risk exposure of specific households and firms.
3. Because of item 2, the liquidity risks are uninsurable; that is, no private insurance will emerge because, given imperfect information, insurance may well set deposit insurance premiums in such a way as to induce many households and firms to take liquidity risks.
In such a system, households and firms will undertake less long-term, illiquid investment projects than they otherwise bear excessive, uninsurable, risks Here is where depository institutions emerge. They offer deposit contracts that are convertible into currency at a one-to-one exchange upon demand; they thereby substitute their own liquidity risk for non-financial firms "liquidity risk, and they do so with the hope of earnings profits. While this arrangement leaves everyone better off and promotes economic growth, it also has its disadvantages: Occasionally bank runs arise and depository institutions fail-bringing households and firms down with them
the benefits to society of deposit insurance we have established the fact that by accepting such highly liquid liabilities as demand deposit and savings accounts, banks and thrifts have gone into the businesses of substituting their own liquidity risk for the liquidity risk of households and firms, in an attempt to earn profits. But this now merely transfers the inherent problem concerning a lack of information about financial strength from individuals and businesses to depository institution. Individual depositors have imperfect information concerning (1) how risky and how liquid the depository institution is asset portfolio is and (2) when, and how much, other depositors wish to withdraw. Furthermore, depository institutions typically employ a "first-come, first-served" rule in honoring deposit redemption.
Because depositors Know that not all depositors can get their funds back, one ‘s place in line matters and runs are possible. Note that runs are quite rational from the individual depositor‘s point of view. But there are social costs to runs: Runs on insolvent depository institutions may lead to runs on solvent institution; and if many banking institutions fail, the total quantity of credit-and of money, because demand and other checkable deposits are part of the quantity of money-will fall dramatically. As a result, the flow of economic activity-national income, national output, and employment-can be adversely affected. enter the federal deposit insurance scheme.
Now the insurer Has the problem Note, however, that the problem concerning lack of information about specific enterprise remains. the Federal deposit insurer must now be concerned with the solvency of those institutions that it is insuring. the insurer, therefore, incurs the costs of gathering and evaluating information about the condition of depository institutions; those costs exist whether or not a specific institution fails. if an institution does fail, the federal deposit insurer incurs the additional expense of paying the claims of the insured depositors.
If the deposit insurer does not price its services properly, then depository institutions have an incentive to increase their profits by taking on additional risk. but in practice it is extremely difficult for even the federal deposit insurer to measure the risk of insured banks. Presumably the risk of an insured bank to the federal deposit insurer is indicated by the variation in the bank‘s future net income stream; but one cannot directly observe today the future results of specific bank management decision. in practice, deposit insurers measure a bank ‘s risk by the degree of variability in its past earnings.