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

Hong Mao; Krzysztof Ostaszewski; Jin Wang

doi:10.58567/jea02040008

Authors

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

DOI:

https://doi.org/10.58567/jea02040008

Keywords:

Deposit Insurance, Capitalization, Critical Conditions, Sensitivity Analysis

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.

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