The bank-depositor relationship and bank incentives to invest in risky assets

This study investigated a basic hypothesis: In an economy with no deposit insurance, and in which banks know more about the risk level of their portfolios of assets than do depositors, banks have incentive to invest in risky portfolios.;The study builds on previous theoretical work supporting the notion that banks have private information not shared with depositors about the risk level of asset portfolios. Knowing that greater risk increases the possibility of bank failure and loss of depositor funds, depositors will be concerned about the risk associated with bank loan portfolios in an economy with no regulation (no deposit insurance). The required rate of return (interest) on deposits will incorporate a risk premium accounting for banks' ability to benefit from asymmetric information by investing in high-risk portfolios. Depositors require the higher interest rate as a means of settling up on a period-by-period basis. The combination of including a risk premium in the interest rate and being able to make high-risk investments with little likelihood of being detected encourages banks to invest in risky assets.;This study employs a variety of utility functions to represent bank-depositor welfare and to investigate the research hypothesis. The resulting models incorporate the decision rules of forward-looking depositors and banks. The models are then solved for optimal and time-consistent levels of portfolio risk. For each utility function, the equilibrium level of risk is greater than optimal, and combined bank-depositor utility is lower when there is asymmetric information. Each model is then modified and interpreted to incorporate the effects of deposit insurance systems with either flat-rate or risk-related premiums. Depending upon the type of insurance system implemented, banks have more or less incentive to invest in risky assets. Various policy tools available to a government regulator are then considered in the context of each model to provide further insights into the effects of these policies on bank risk-taking behavior.