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Critical condition for deposit insurance to partially or fully substitute for raising capital under cyclical economic environment

Author

Listed:
  • Hong Mao

    (Shanghai Second Polytechnic University, Shanghai, China)

  • Krzysztof Ostaszewski

    (Department of Mathematics, Illinois State University, Illinois, USA)

  • Jin Wang

    (Office of Information Security, Beijing, China)

Abstract

Regulation of financial institutions has two key purposes: Solvency (prudential regulation) and consumer protection. Prudential regulation is implemented mainly by capital requirements, but governments also provide insurance for customer deposits, as a backup tool. In this article, we discuss the critical conditions for deposit insurance and capitalization to act as substitutes for each other, under cyclical economic environment. We make two assumptions. The first one is that deposit insurance is fairly priced and there is no moral hazard. The second one is that insurance creates incentives for moral hazard among insured banks, resulting in increased risk taking. We also discuss the critical conditions for deposit insurance and capitalization to be complementary under different proportions of deposit insurance.

Suggested Citation

  • Hong Mao & Krzysztof Ostaszewski & Jin Wang, 2023. "Critical condition for deposit insurance to partially or fully substitute for raising capital under cyclical economic environment," Journal of Economic Analysis, Anser Press, vol. 2(4), pages 140-153, July.
    • Handle: RePEc:bba:j00001:v:2:y:2023:i:4:p:140-153:d:148
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    References listed on IDEAS

    as
    1. James, Christopher, 1987. "Some evidence on the uniqueness of bank loans," Journal of Financial Economics, Elsevier, vol. 19(2), pages 217-235, December.
    2. Mao, Hong & Cheng, Jiang, 2020. "Optimal capitalization and deposit insurance strategies with regard to moral hazard," Journal of Economics and Business, Elsevier, vol. 108(C).
    3. Fama, Eugene F., 1985. "What's different about banks?," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 29-39, January.
    4. Douglas W. Diamond & Anil K. Kashyap & Raghuram G. Rajan, 2017. "Banking and the Evolving Objectives of Bank Regulation," Journal of Political Economy, University of Chicago Press, vol. 125(6), pages 1812-1825.
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