Common Deposit Insurance, Cross-Border banks and Welfare

Abstract

We study the effects of the introduction of common deposit insurance across countries in a model of cross-border banks with both endogenous risk-taking and within group risk-sharing possibilities. With national deposit insurance, there is inefficient ring-fencing of resources from healthy to impaired subsidiaries for high asset correlation, which reduces cross-border bank integration. Common deposit insurance removes ring-fencing and encourages cross-border integration, but has an ambiguous impact on the banks’ risk-taking due to opposing franchise value and liquidation threat effects. Common deposit insurance is welfare increasing for risky enough banks, but otherwise leads to excessive cross-border integration and lower welfare.

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