The Incentive-Compatible Design of Deposit Insurance and Bank Failure Resolution

Abstract

Deposit insurance and bank failure resolution are important parts of the financial safety net and an incentive-compatible design of both can minimize the probability and cost of financial fragility. The absence of explicit deposit insurance or the proper design of an explicit scheme can encourage large depositors and creditors to monitor banks and exert market discipline, thus reducing the risk of aggressive risk-taking by banks and thus the risk of financial fragility. Effective and timely resolution of failed banks can decrease the cost that bank failures can cause to the banking system. An incentive-compatible design of bank failure resolution can contain aggressive risk-taking by banks and thus reduce the probability of bank failures ex-ante.

The author would like to thank Robert Cull, Augusto de la Torre and participants at the Bank Insolvency Conference of the Bank of Finland for useful comments and discussions. This chapter’s findings, interpretations, and conclusions are entirely those of the author and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.