Sunday, October 11, 2009: 11:55 AM
On September 30, 2008 Ireland unexpectedly declared unlimited deposit insurance for its largest banks. On October 5, 2008 Germany announced that it would provide unlimited deposit insurance on all privately held deposits in domestic banks. Two days later in an emergency European Union summit, the member states agreed to raise the minimum deposit guarantees from €20,000 to €50,000 in response to “a number of Member States” providing more than €20,000. At the summit, it was reported that the Irish representative received a decidedly less than warm welcome.
This paper tries to understand the response of matching increases in deposit insurance as an equilibrium strategic best response (rather than a common optimizing response to a common shock). A simple model is developed in which deposit insurance effects deposit flows between countries. Countries non-cooperatively choose deposit insurance provision. A country that provides more deposit insurance forces other countries to closely follow suit in times of increased financial stress. The new equilibrium may not be welfare improving. Greater deposit insurance increases the potential liabilities of taxpayers and induces moral hazard that weakens the banking system.
We also examine the incentives of a country to unilaterally increase its deposit insurance. When there is a first-mover advantage, a unilateral increase in deposit insurance beggars-thy-neighbour. Without a first-mover advantage, a country may increase their deposit insurance to stabilize their banking system in a crisis. This may be optimal even if they incur the wrath of their neighbours. Here, deposit insurance is the mechanism by which a crisis in one nation propagates to other nations.
This paper tries to understand the response of matching increases in deposit insurance as an equilibrium strategic best response (rather than a common optimizing response to a common shock). A simple model is developed in which deposit insurance effects deposit flows between countries. Countries non-cooperatively choose deposit insurance provision. A country that provides more deposit insurance forces other countries to closely follow suit in times of increased financial stress. The new equilibrium may not be welfare improving. Greater deposit insurance increases the potential liabilities of taxpayers and induces moral hazard that weakens the banking system.
We also examine the incentives of a country to unilaterally increase its deposit insurance. When there is a first-mover advantage, a unilateral increase in deposit insurance beggars-thy-neighbour. Without a first-mover advantage, a country may increase their deposit insurance to stabilize their banking system in a crisis. This may be optimal even if they incur the wrath of their neighbours. Here, deposit insurance is the mechanism by which a crisis in one nation propagates to other nations.