Fairly priced deposit insurance under adverse selection

Fair pricing of deposit insurance represents one of the most difficult problems of bank regulation. This paper introduces an incentive mechanism such that fair (risk-based) deposit insurance premiums can be achieved under adverse selection. The deposit insurer screens banks by offering full insurance coverage for high-risk banks and partial coverage for low-risk banks. If deposit interest rates can be regulated, low-risk banks can also obtain full coverage. The optimal solution may require dividing deposits into junior and senior deposits. More generally, our analysis connects deposit insurance with standard insurance theory.