Policy Portfolio for Banks: Deposit Insurance and Liquidity Injection

Abstract

Banking crises pose significant threats to our economy, leading to the implementation of policy measures such as deposit insurance and liquidity injection to strengthen financial stability and optimize resource allocation efficiency. This paper investigates the dynamic interplay between deposit insurance and liquidity injection. Facing uncertainty regarding bank health and depositor liquidity shocks, policymakers decide liquidity injection based on withdrawals. While higher deposit insurance coverage can mitigate panic runs, it may undermine the effectiveness of liquidity injections. We demonstrate that liquidity injection overshadows deposit insurance. Consequently, the optimal policy portfolio entails zero deposit insurance, enhancing resource allocation efficiency but leading to more panic runs. Joint paper with Chong Huang and Junyuan Zou.