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Designing deposit insurance scheme under asymmetric information with double liability option

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Abstract:

In this article, an option theoretic model is applied to develop a Deposit Insurance Scheme under asymmetric information environment. By introducing double liability as an option into the deposit insurance scheme, our model solves the Deposit Insurer's adverse selection problem. With appropriately designed deposit insurance premia and double liability obligations, we demonstrate that separating equilibria exist. The introduction of double liability into the current deposit insurance system adds additional cost to the system to make the insurance scheme more effective. Macey and Miller (1992) suggest that such double liability is a very useful tool for preventing the incentive problem typically created by current deposit insurance schemes. Based on Jackson (1993), Macey and Miller (1993) and Grossman (2002), no consensus exists to explain whether double liability can replace the current deposit insurance system. There are two companion issues that must be considered. The first is the preservation of the safety of the financial system. The second is the incentive created by current deposit insurance schemes for managers to take extra risk. This is an attempt to create a model in which both the deposit insurance premiums and double liability issues are integrated in a manner that preserves incentive compatibility, while embracing risk-sensitive deposit insurance policy.

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/09603100600843908

Affiliations: 1: Assistant Professor of Finance, College of Business Administration, California State University, Sacramento, CA 95819, USA 2: Technical Director, Wharton Research Data Services, Wharton School, University of Pennsylvania, Philadelphia, PA 19104.6301, USA

Publication date: July 1, 2007

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