Deposit Insurance Flashcards
How to reduce the moral hazard issue?
*∅ is the probability for success in projects
To reduce the moral hazard issue, risk-based pricing of P is necessary. So we want to make the profit (π), an increasing function of ∅ In other words, we want to make it more profitable to pursue projects that has a high chance of succeeding. Also, we want to do P so that it increases when ∅ decreases. This will give incentives to the bank to pursue safer, less risky projects. (π)/∅ > 0
What can we conclude from π/∅ =-D < 0
From this we can conslude that profit π would decrease in ∅, since -D is negative. Therefore, the fixed premium in this model doens not reduce the moral hazard issue of the profit model.
What is the actuarially fair price of P in this model?
The actrually fair price: The value of P makes the net contribution zero: (1-∅)D-P=0 => P =(1-∅)D
