RISK-TAKING INCENTIVES OF BANKS AND RISK-ADJUSTED DEPOSIT INSURANCE

The manager of a depository institution is shown to exhibit risk‐taking behavior under the current insurance arrangement. Perfect monitoring or risk‐based deposit insurance would eliminate this incentive if information were symmetric between bank managers and the insuring agency. Absent symmetric information, it is shown that a recently suggested scheme, where insurers collect insurance premiums based on projected and actual risk levels, does not control the risk‐taking incentive. The only way to control this incentive through insurance rates is to levy a relatively high premium, which is not actuarially fair. © The Southern Finance Association and the Southwestern Finance Association