Deposit guarantee evaluation and incentives analysis in a mutual guarantee system Maria Elena De Giuli a, * , Mario Alessandro Maggi a , Francesco Maria Paris b a Department of Economics and Quantitative Methods, University of Pavia, via S. Felice, 5, 27100 Pavia, Italy b Department of Quantitative Methods, University of Brescia, Italy article info Article history: Received 1 July 2008 Accepted 29 November 2008 Available online 31 December 2008 JEL classification: G13 G18 G21 Keywords: Deposit insurance Mutual guarantee system Incentives evaluation Option pricing Forbearance abstract This paper analyzes how the deposit guarantee value affects the risk incentives in a mutual guarantee system. We liken the guarantee’s value to that of a European-style contingent claims portfolio. The main feature emerging from our model is that a mutual guarantee system would give banks an adverse incen- tive to increase riskiness. To mitigate this incentive, we introduce a regulatory provision modelled using a path-dependent contingent claim. By comparing the mutual guarantee system with a non-mutual one, we show that the former is less expensive, but implies higher adverse incentives for the banks, especially for undercapitalized institutions. Ó 2009 Elsevier B.V. All rights reserved. 1. Introduction Research on deposit insurance has been carried out in different fields, such as the designing of deposit insurance systems, the eval- uation of deposit insurance premiums, and the study of the eco- nomics of deposit insurance systems. An extensive theoretical literature, supported by cross-country empirical analyses, com- pares alternative insurance structures, discusses the role and the goals of deposit insurance, and compares the current practices em- ployed to establish an efficient deposit insurance system. 1 The pri- mary objectives of deposit insurance systems are the protection of the depositors and the stability of the banking system. How these aims are met is country specific. Each single country designs its insurance system to suit its own economic, institutional and political situation. Moreover, deposit insurance system features can be very different. Take for instance provision which can be assigned either to a public, private or mixed agency; participation in the system which can be mandatory or voluntary; financial resources which can be collected via ex-ante contributions or by ex-post raising funds, only when needed, or coverage which can be blanket or lim- ited. While deposit insurance enhances the stability of the banking system and protects the depositors, it also creates moral hazard, increasing the banks’ risk-taking incentive. Moral hazard is one cost of such a safety net. While depositors need not monitor banks, since their deposits are guaranteed up to coverage limit, the banks can use this coverage to increase their riskiness. 2 Following Kuritzkes et al. (2002), we argue that the design of a deposit insurance system should answer the following questions: (1) How large should the fund be in order to protect depositors? (2) How should coverage be priced? (3) Who pays in the event of losses? In this paper the reference framework is a mutual guarantee system. In this system, banks cooperate to insure themselves con- tributing to an interbank fund. If any bank fails, the deposit protec- tion agency (i.e. the bank consortium managing the interbank fund) covers the losses suffered by depositors, up to a given amount. If the consortium falls short, the residual losses are cov- ered by the government. Insured banks can therefore shift the costs related to depositor reimbursements to the government without challenging the depositors’ integrity. In these systems, moral haz- ard produces an adverse selection among banks. Therefore, solvent 0378-4266/$ - see front matter Ó 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2008.11.013 * Corresponding author. Tel.: +39 0382986236; fax: +39 0382304226. E-mail addresses: elena.degiuli@unipv.it (M.E. De Giuli), maggma@eco.unipv.it (M.A. Maggi). 1 See, e.g. Calomiris (1989, 1990), Demirgüç-Kunt and Kane (2002), FDIC (2000, 2003), Garcia (1999), Huizinga and Nicodème (2006), Laeven (2002a,b, 2004), and Nikitin and Smith, 2008). 2 See, e.g. Agusman et al. (2008), Ely (1999), Hovakimian et al. (2002), Imai (2006), Laeven (2002b) and Park and Peristiani, 2007). Journal of Banking & Finance 33 (2009) 1058–1068 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf