This post is authored jointly with our friend and colleague, Thomas Philippon, Max L. Heine Professor of Finance at the NYU Stern School of Business

Deposit insurance is a key regulatory tool for limiting bank runs and panics. In the United States, the Federal Deposit Insurance Corporation (FDIC) has insured bank deposits since 1934. FDIC-insured deposits are protected by a credible government guarantee, so there is little incentive to run.

However, deposit insurance creates moral hazard. By eliminating the incentive of depositors to monitor their banks, it encourages bank managers to rely on low-cost insured deposits to fund risky activities. In the extreme, with 100% deposit insurance coverage, banks would have virtually no incentive to issue equity or debt.

Against this background, and in light of the events of March-April 2023, we ask what is to be done about deposit insurance. To prevent bank runs, should there be an increase in the legal limit? If so, how can authorities balance the costs of runs and panics against the costs associated with moral hazard, while keeping in mind the potential financial burden on the public? Or, are there alternatives?

We emphasize three promising ways to enhance deposit insurance: a higher insurance cap for small and medium-sized enterprises (SMEs), new resolution rules, and the option to purchase supplementary deposit insurance. In addition, and as regular readers of this blog might expect, we also think that higher capital requirements should be part of the solution: if we require that banks increase the degree to which they finance their assets with capital (rather than deposits), the risk of runs and panics would decline even without raising the cap on deposit insurance….