Deposit Insurance and Financial Development
Cull, Robert, Senbet, Lemma W., Sorge, Marco, Journal of Money, Credit & Banking
Do DEPOSIT insurance programs contribute to financial development? Why have so many governments adopted such programs, and what did they expect to achieve? We conduct an empirical analysis to examine the effect of deposit insurance on the size and volatility of the banking sector. Governments in advanced economies and many developing economies grant explicit (1) deposit insurance in the hope of reducing the risk of systemic failure. (2) In other words, the introduction of deposit insurance is presumed to stabilize the financial system by forestalling hasty fire-sale losses on assets that could bring down other banks and disrupt financial markets and the payments system. Moreover, by bolstering depositors' faith in the stability of the system, deposit insurance may lead to a deeper financial system, which could contribute to higher economic growth rates. (3)
However, we argue that deposit insurance can be socially counterproductive if the system is not appropriately structured. Under many deposit insurance schemes, if a depository institution, such as a savings and loan firm, goes bankrupt, the government absorbs all (or nearly all) of the depositors' losses. This weakens market discipline (i.e., monitoring of bank activities by depositors and other bank stakeholders) and creates a moral hazard problem, since there is now an incentive for depository institutions to engage in excessively high-risk activities, relative to socially optimal outcomes. Especially in lax regulatory environments, these incentives are likely to lead to greater systemic instability.
The central issue that we address is the impact of deposit insurance programs on financial stability and financial development. The stability question is complementary to existing papers, particularly a recent study by Demirguc-Kunt and Detragiache (2002). Based on evidence for 61 countries between 1980 and 1997, Demirguc -Kunt and Detragiache (2000) find that variations in coverage, funding or management of deposit insurance schemes are significant determinants of the likelihood of banking crisis, especially across countries where interest rates have been deregulated and the overall institutional framework is weak. We focus on the impact of explicit deposit insurance on financial stability and development over a longer horizon, and not only when a financial or banking system collapses into a crisis. Accordingly, our empirics are not based on crisis data alone.
In short, we focus on the steady-state, forward-looking effects of deposit insurance. Recent events have shown that in times of crises, no matter whether deposit insurance is implicit or explicit, depositors tend to be bailed out anyway when systemic problems arise. (4) Ex ante bail-out expectations, however, do influence bank risk-taking behavior even in stable circumstances, by truncating the negative tail of the distribution of returns, and our empirical tests are designed to measure these effects.
Moreover, our paper extends the empirical analysis of deposit insurance schemes in a couple of ways. First, we directly address the sample selection problems inherent in analyzing the effects of deposit insurance programs. The sample of countries that adopt explicit deposit insurance is clearly not random, and thus we employ statistical techniques that account for this selection process (Hovakimian, Kane, and Leaven  employ similar techniques). This approach will also allow us to overcome the difficulty in categorizing variations in coverage or funding within the heterogeneous spectrum of countries lacking an official insurance arrangement.
Further, the same explicit deposit insurance program will probably have different effects depending on the general institutional environment. For example, a recent article by Gropp and Vesala (2001) argues that in Europe, implicit insurance has meant an even higher potential for moral hazard than explicit systems. This is because, though it introduces some uncertainty of being bailed out, the coverage of implicit insurance may extend to a larger set of bank stakeholders compared to the case of explicit laws protecting depositors alone. …