Optimal Regulation of a Fully Insured Deposit Banking System

We analyze risk sensitive incentive compatible deposit insurance in the presence of private information when the market value of deposit insurance can be determined using Mertonis (1977) formula. We show that, under the assumption that transferring funds from taxpayers to financial institutions has a social cost, the optimal regulation combines different levels of capital requirements combined with decreasing premia on deposit insurance. On the other hand, it is never efficient to require the banks to hold riskless assets, so that narrow banking is not efficient. Finally, chartering banks is necessary in order to decrease the cost of asymmetric information