Monetary and Economic Studies Vol.11, No.1 / July 1993

Deposit Insurance and Moral Hazard

Mitsuru Iwamura

It is well known that deposit insurance creates a "moral hazard" problem as it increases the risk attaching to the asset portfolios of commercial banks. However, no precise answers have been given as to what characterize the risk incentive mechanism of commercial banks under deposit insurance systems, and as to whether the system of variable deposit insurance premiums, which is often regarded as a more consistent framework, can resolve the "moral hazard" problem. The purpose of this paper is to estimate the risk premiums of deposit insurance systems, using numerical integration under certain simplified assumptions, and to offer some answers to the above questions. The functions of Japan's deposit insurance system extend beyond simple insurance payoffs and include rescue operations and merger assistance. The former function guarantees only the principal of bank deposits while the latter covers both principal and interest. These functional differences create some difficulties in resolving the "moral hazard" problem.

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 1993 Bank of Japan All Rights Reserved.

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