Many financial contracts have the primary purpose of transferring risk between different economic agents. In recent decades, innovations by private financial institutions and markets in the form of derivatives and other securities have expanded the opportunities for allocating risks. However, for many years the federal government has offered insurance contracts that shift risk from private entities to taxpayers. Its role as an insurer of private risks continues to be large despite the private financial innovations that might be expected to supplant it.

This paper considers how the largest federal insurance program, deposit insurance, influences financial system risks. I focus on how the presence of this insurance can change the investment decisions of individuals, banks, and firms. While a government deposit guarantee may produce risk-sharing benefits, I argue that the current methods for pricing this guarantee and for regulating banks are leading to new forms of moral hazard that are killing off efficient private financial innovations. Moral hazard is also created because insurance mis-pricing and capital regulations have the effect of subsidizing systematic risks. I then explore the possibility that there are alternative ways that a government might offer deposit insurance that produce less inefficiencies.