Optimal Deposit Insurance

This paper characterizes the optimal level of deposit insurance (DI) when bank runs are possible. In a wide variety of environments, the optimal level of DI only depends on three sufficient statistics: the sensitivity of the likelihood of bank failure with respect to the level of DI, the utility loss caused by bank failure (which is a function of the drop in depositors’ consumption) and the expected economy-wide marginal resource loss in bank failure states, which directly depends on the marginal cost of public funds and the illiquidity/insolvency status of banks. As long as banks are competitive, changes in banks’ behavior induced by varying the level of DI (often referred to as moral hazard) only affect the level of optimal DI directly through a fiscal externality that reduces available resources in bank failure states, but not independently. We characterize the wedges that determine the optimal ex-ante regulation (which can be mapped to deposit rate limits or deposit insurance premia) and study the practical implications of our framework when calibrated to US data. JEL numbers: G21, G28, G01