Optimal Interest Margin, Deposit Insurance Premium and Bank Size

Abstract

This paper models the effect of bank competition and deposit insurance premia on the spread between lending and deposit rates. Low spreads do not always indicate bank efficiency in developing economies, but may be the result of high risk-taking. The optimal intermediation spread is characterized as the outcome of a deposit game played among banks with different asset size. This paper shows that imposing an upper and a lower limit on banks' spreads, and adjusting the deposit insurance premia when violation of these limits occurs, leads to a more stable, but relatively large intermediation cost. In developing economies, such an outcome would be considered as more desirable since it insulates the existing financial intermediaries and the investors against macroeconomic disturbances.