Join us to explore how deposit insurance and liquidity support interact, and why zero insurance might improve financial stability and resource allocation.
Abstract
To promote financial stability and improve resource allocation, policymakers establish a safety net built on two key policy tools: deposit insurance and liquidity support. This paper examines the dynamic interaction between the two policy tools. In our model, the efficiency of liquidity injection hinges on the policymaker's ability to infer bank fundamentals from early withdrawals, which may be driven by aggregate liquidity shocks or informed depositors' actions. We show that deposit insurance dampens depositors' incentive to act on private information, impairing the policymaker's learning and reducing the efficiency of liquidity injection. As a result, the optimal policy portfolio involves zero deposit insurance—trading off more panic runs for more efficient resource allocation.
