Question

How does a risk-based deposit insurance program solve the moral hazard problem of excessive risk taking by banks?

Answer 1

Moral hazard is the idea that a party protected in some way from risk will act differently than if they didn't have that protection. We encounter moral hazard problems in our life like - tenured professors becoming indifferent lecturers, people with theft insurance being less vigilant about where they park, etc.
Moral hazard is usually applied to the insurance industry. Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking, which results in them paying more in claims.
The idea of a corporation being too big to fail also represents a moral hazard. If the public and the management of a corporation believe the company will receive a financial bailout to keep it going, management may take more risks in pursuit of profit. Government safety nets against the fallouts of the market like risks of meltdown, crashes, & panics create moral hazards that lead to more risk-taking in the future.
Moral hazard occurs in the financial institution & banking industry when the provision of deposit insurance or other liability guarantees encourages the institution to accept asset risks that are greater than the risks that would have been accepted without such liability insurance.

Deposit insurance is a part of the "safety net" for the banking system. The double role of banks as liquidity providers & participants in the credit & capital marke tmakes them potentially vulnerable to the bank runs. Secondly, banks are generally opaque entities making it difficlut for depositors & other creditorsto evaluate the default risk of each bank. The limited information among depositors about the risk & value of bank assets can lead to the spraed of bank runs from one bank to other banks.HEnce the banking industry basically suffers from systematic risk. Hence the govt has provided a safety net for the banking industry in the form of different measures like deposit insurance, supervision & regulation of bank's risk taking capacities, capital requirements, lender of last resort etc.

Deposit insurance can limit the risk of bank runs by guaranteeing that depositors receive some, or all of their deposited funds with reasonable speed in case their banks become insovent or illiquid. However, the flip siade of the positive role of deposit insurance as a safeguard against bank runs & as a consumer protection device is its role in inducing banks to shift risk to a deposit insurance fund or tax payers. This risk shifting incentives ar caused by limited liability of shareholders & explicit or implicit protection of customers/depositors & otehr creditors. These factors hence give rise to the moral hazard problem for the banks. This moral hazard problem of banking industry implies that banks have incentives to take on excessive risk on the assests side or to keep the equity capital low. Thus deposit insurance scheme  can contribute to very problem of the systematic risk in the banking industry they are actually designed to reduce. However, one solution to this moral hazard problem would be to design a risk - based deposit insurance premium structure reflecting bank's risk taking. Risk based deposit insurance pricing encounters the problem of defining bank's risk taking contractually. In the United States, the Federal Deposit Insurance Corporationn (FDIC) sets insurance premiums based on the level of capital. Under FDICIA, a system of risk based premium was first propsed in 1992 & got instituted by 1994.The FDIC has propsed a two phase plan for the risk based premiums.

Banks do not deliberately take risks, however it is the competition among the banks with the opportunity to finance their lending activitiesat at a near risk free interest rate taht induces them to prefer debt financing to equity financing. A system of risk-baseddeposit insurance premiums confronts the moral hazard problem directly by ensuring that the banks should be charged a risk premium if they take on excessive risks, so that the bankers can no longer act on private incentives & maximize the riskiness of their assets. Instead, henceforth, the bankers considering a riskier asset portfolio must balance the increased cost of insuring deposits against the benfits of risks to their limited liability stockholders.

Some of the measures of the risk based deposit insurance sheme for the banks are like :- lager differences in the premium between safe & risky institutions, a progressive upward racheting of premiums for institutions that remain in a high-risk category for extended periods of time, & a larger premium matrix incorporating finer gradations of capitalization & supervisory limits.