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To be clear - the problem (the incentive problem, at least) is introduced by the insurance with the cap. If we had an FDIC that mandated premiums, covered deposits up to a certain amount, and did not cap the liabilities that banks face above that amount (so that depositers could sue over losses above the amount guaranteed by FDIC), then it may or may not be efficient - but it should not introduce that perverse incentive, right (assuming, of course, that premiums are high enough to cover the insured losses)? Am I thinking about that right?

In other words - the really perverse thing seems to be the combination of the cap and the insurance.

Daniel, yes, you are correct that the liability cap makes it worse than deposit insurance, because with deposit insurance, the bank still has to pay its liabilities, and will be restructured or liquidated to recover what it can pay, whereas the oil company remains with the same owners and managers as before. The depositors also face the moral hazard with deposit insurance, as they don't mind lending to risky banks, and the availability of funding creates more of a market for risky banks (i.e. it reduces market discipline).

Interestingly, liquidity regulation can also increase risks (see http://www.lostsoulblog.com/2010/03/submission-summary.html )

Would this argument follow that all liability caps are undesirable? What about in the medical malpractice context?

The news is not that social democracies are trying to commit suicide, the problem is to explain how did they succeed in surviving for so long.

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