Can Risk-Based Deposit Insurance Premiums Control Moral Hazard?

C alls for deposit insurance reform regularly sound the refrain to make deposit insurance premiums more risk based.1 Those who support such a change believe that risk-based premiums will discourage insured banks from taking excessive risk because a bank facing higher premiums will think twice before undertaking a risky activity. This logic seems impeccable: Let banks face the true cost of risk and they will appropriately balance the tradeoff between risk and return. While seemingly correct from the standard perspective of price theory, this argument requires the deposit insurer to be able to observe the risk characteristics of a bank’s investment portfolio. There are good reasons to think that this is not the case; it is hard for outsiders to evaluate a bank loan or a complicated portfolio of financial derivatives. Under these conditions, risk-based deposit insurance premiums are not enough to control moral hazard. Instead, other devices such as performance-based insurance payments and supervisory monitoring are needed as well. When one party to a transaction has information that the other party does not have, economists describe the transaction as one with private information. Various types of information may be private, but I am concerned with a payoffrelevant action. This model is sometimes referred to as the moral-hazard or hidden-action model. In this article, the action that may be hidden from others is the risk characteristics of a bank’s investment decisions. The economic literature on moral hazard emphasizes the importance of state-contingent payments