Deposit Insurance, Capital Constraints, and Risk Taking by Banks

Abstract

The paper analyzes the moral hazard problem of the bank, which arises from the inability of claim holders to observe the bank's portfolio choice. The risk-incentive of debt is mitigated by diversification of the bank portfolio. It is shown that when the marginal source of funding of the bank is not deposits, but funds raised in the capital market, deposit insurance may induce the bank to take less risk rather than more. If deposit insurance is fairly priced, there is no scope for capital constraints, but, with a constant insurance premium, a capital requirement can reduce risk-taking by the bank