Bank runs, information costs and deposit insurance reform

Deposit insurance has been widely praised for its role in stabilizing the U.S. banking system. Despite its success, however, the system has been criticized for inducing banks to take socially excessive risks. Various deposit insurance reform proposals have been discussed in the literature. In this dissertation, several of these proposals are evaluated. It is argued that reform proposals which rely upon depositors to discipline depository institutions cannot be effective because depositors have very little incentive to become informed. It is argued, that monopolistic, governmental insurers do not have the incentive to properly price their product, hence proposals to introduce centralized discipline are ineffective. Private deposit insurance has also been suggested. The empirical evidence suggests, however, that private insurers do not have the ability to provide an effective deposit guarantee.;It is argued in this dissertation that bank shareholders, rather than depositors or insurers, have both the incentive and the ability to discipline bank management. This dissertation calls for a reform of the banking system and increased reliance upon shareholder discipline.;In this proposal, deposit funds are placed in escrow for the depositors. In the escrow account, the bank holds liquid marketable securities whose value can be monitored daily. This allows a bank overseer to enforce a market value closure rule for banks. Because marketable securities are not risk-free, bank shareholders insulate depositors from losses by collateralizing a small percentage of the capital base to the depositors. This arrangement is similar to margin requirements in futures markets. At a minimum, the margin requirement in this proposal equals the largest possible one-day decline in the value of the securities.;Despite this deposit guarantee, which is similar to a 100% reserve requirement, banks continue to exercise their comparative advantage in evaluating, processing and funding business and consumer loans. The funding, however, comes from equity shares in the bank. Using equity financing has several advantages over deposit funding. First, this type of funding arrangement reverses the maturity mismatch between bank assets and bank claims so bank runs are eliminated. Most important the secondary market for bank securities, unlike the deposit market or the quasi-governmental insurance agencies, provides a powerful and efficient source of discipline to bank decision makers.