Surety bonds and moral hazard in banking

Vol: 
104/2020
Author name: 
Dwyer GP
Hasman A
Samartin M
Year: 
2020
Month: 
December
Abstract: 

We examine a policy in which owners of banks provide funds in the form of a surety bond in addition to equity capital. This policy would require banks to provide the regulator with funds that could be invested in marketable securities. Investors in the bank receive the income from the surety bond as long as the bank is in business. The capital value could be used by bank regulators to pay off the banks’ liabilities in case of bank failure. After paying depositors, investors would receive the remaining funds, if any. Analytically, this instrument is a way of creating charter value but, as opposed to Keeley (1990) and Hellman, Murdock and Stiglitz (2000), restrictions on competition are not necessary to generate positive rents. We demonstrate that capital requirements alone cannot prevent the moral hazard problem arising from deposit insurance. A sufficiently high level of the surety bond with deposit insurance, though, can prevent bank runs and does not introduce moral hazard.

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