Deposit insurance, Bank Regulation, and Financial System Risks George Pennacchi

1. Deposit insurance, Bank Regulation, and Financial System RisksGeorge Pennacchi • Three papers in one • Gatev and Strahan redux • An observation about insurance pricing • Proposal for providing insured medium of exchange without distorting financial markets.

2. 1. Banks enjoy a liquidity inflow when market liquidity dries up only after 1930s. Empirical work reinforced by observation that “U.S. banks appear to have made little, if any, formal loan commitments prior to 1933.” Anyone here know about this? Kashyap-Rajan-Stein model derives from safety net, not simply scope economies.

3. 2. Actuarially fair insurance premia distort bank investment decisions. E(R) SML Rf + δ(σ) Rf β(given σ) Government’s “inherent limitations” make it unlikely that non-distorting insurance premia will be applied.

4. 3. Mitigate distortions by insuring MMMF, not banks. Insurance Premium = RMMMF - Rf • Toasters again? • What permits the (uninsured) banks to fail? • will still be “fragile” • time consistency problem (“constructive ambiguity”) • Diamond and Rajan’s idea that interfering with fragile institutions can do more harm than good.

5. Is Deposit Insurance A Good Thing And, If So, Who Should Pay For It?Morrison and White Great question: what’s the social value of deposit insurance? Frame the question in a new way.

6. Simple model with • moral hazard: bankers must be paid to monitor • adverse selection: depositors know some banks are “bad”, but not which ones. Investors can earn RpL for themselves, or deposit in a bank that will pay • RpL – Q if the bank is “bad” and can’t monitor • RpH – Q if the bank is “good” and monitors Monitoring is a good thing: RΔp > C

7. Optimally, everyone deposits her wealth in a bank. But depositors worry: “Which sort of bank to I have?” Roughly, the paper recommends that resources from outside the bank-depositor group subsidize banks’ monitoring.

8. Is there a better equilibrium? As presented, the model may be too simple. Good banks add value not by screening but by monitoring, whose value is entirely captured by borrowers. It seems the borrowers can/should pay for monitoring.

9. The good banks promise to pay (RpH – C) per deposit dollar (> RpL) • Good banks charge borrowers RpH, which leaves them as well off as they’d be with bad banker or floating debt in the market. • If the bank actually monitors, the banker earns [RpH – C] on her own funds. (Like Diamond ‘84.) • If banker does not monitor, his loans repay only RpL and he is left with less than RpL after paying depositors their promised interest.

10. BONUS: the “bad” banker drops out on his own. Could worry about competition among bankers for depositors or borrowers • might re-arrange surplus created by monitoring. • would not leave a worse optimum than in the model presented in the paper.

11. “Determinants of Deposit Insurance Adoption and Design”Kane et al. Start out by observing: this is an awesome data set. Extend a paper by Laeven [2004]: which nations adopt EDIS and what determines the system’s design?

12. Adoption: Tables 5 and 10 (+) Pr(Adoption)i = α0 + α1 (GDP per capita) + (+) (+) α2 (Ext. Press.) + α3 (Exec. Constr.) + εi Similar result from hazard function.

13. Estimating the adopted system’s “moral hazard” index … …. involves a “selected” sample. Hence Heckman: Pr(Adoption)i = α0 + α1 Zi + εi (+) (M.H. Index)i = b0 + b1(X i)+ b2 (IMR)i + μi IMR > 0 for a surprising adoption IMR < 0 for a surprising NON-adoption b2 ~ cov (εi , μi)

14. b2 > 0  high εi implies high μi If a country has low GDP, etc. but still adopts, its εi must be high and so will be μi. That is, the country tends to adopt a poorly-designed system. And vice versa. Even the unobserved variables seem to conspire.

15. Summary: Three papers about “deposit insurance”. Each one is thought-provoking in its own way.