Bank Capitalization, Deposit Insurance, and Risk Categorization

This article examines the complementary relationship between bank capitalization and deposit insurance as tools that reduce the exposure of risk-averse depositors to a bank's random portfolio returns. In a costly state verification framework where banks possess private information about solvency, we establish that debt contracts are optimal and that banks both capitalize and purchase insurance. Moreover, optimal insurance contracts charge premiums which are conditioned on bank risk as indicated by the level of capitalization. A full-insurance scheme without risk categorization results in an equilibrium where banks totally decapitalize.