Deposit Insurance and the Global Financial Crisis

How does deposit insurance affect bank stability?  This is a question that has been around for a while but has come up again after the global financial crisis.  In response to the crisis, a number of countries substantially increased the coverage of their safety nets in order to restore market confidence and to avert potential contagious runs on their banking sectors.  Critiques worry that such actions are likely to further undermine market discipline, causing more instability down the line. My earlier research on this issue suggests that on average deposit insurance can exacerbate moral hazard problems in bank lending, making systems more fragile.  In other words, particularly in institutionally under-developed countries, banks have a tendency to exploit the availability of insured deposits and increase their risk, making the financial system more crises prone.  This is ironic since deposit insurance is supposed to make the systems more stable, not less.

But what if the impact of deposit insurance on stability varies depending on the economic conditions? Does deposit insurance help stabilize banking systems by enhancing depositor confidence during turbulent times?

This is the question we try to answer in a new paper with Deniz Anginer and Min Zhu where we take advantage of the latest global financial crisis. Specifically, using a sample of 4,109 publicly traded banks in 96 countries, we examine the impact of deposit insurance on bank risk and systemic stability separately for the crisis period from 2007 to 2009, as well as the three years from 2004 to 2006 leading up to the global financial crisis.  We use z-score  (a commonly-used accounting measure of bank risk) and stock return volatility to measure standalone risk of an individual bank, and the marginal expected shortfall (MES) of Acharya, Engle and Richardson (2012) to measure the risk posed by an individual bank to the banking system as a whole.

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We find that generous financial safety nets increase bank risk and reduce systemic stability in non-crisis years.  However, bank risk is lower and systemic stability is greater during the global financial crisis in countries with deposit insurance coverage.  Nevertheless, consistent with the earlier literature, the overall effect of deposit insurance over the full sample we study remains negative since the destabilizing effect during normal times is greater in magnitude compared to the stabilizing effect during global turbulence.  Hence our findings suggest that the “moral hazard effect” of deposit insurance dominates in good times while the “stabilization effect” of deposit insurance dominates in turbulent times.  But since generous safety net policies may be leading to instability in the first place, that they help stabilize during this instability may provide little comfort. After all, the overall effect of deposit insurance over the sample is still negative.

Those of you who are familiar with the earlier literature will not be surprised that the quality of regulation and supervision again ends up being the key factor in keeping moral hazard in check and reaping stabilization benefits of deposit insurance.  We can see this when we study the impact of the regulatory and institutional framework on the deposit insurance and systemic risk relationship. The adverse consequence of deposit insurance may well depend on the institutional environment and can potentially be mitigated through bank regulation.  For instance, better bank supervision may limit the extent to which banks can engage in correlated risk taking activities in the presence of deposit insurance.  We consider a bank supervisory quality index, which measures whether the supervisory authorities have the power and the authority to take specific preventive and corrective actions such as replacing the management team.  We find that good bank supervision and regulation enhances the stabilization effects during crisis periods while dampening the negative effects associated with moral hazard during normal times.

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Our results stress the importance of the underlying regulatory and institutional framework and lend support to the view that fostering the appropriate incentive framework is very important for ensuring systemic stability.

Further reading:

Anginer, Deniz; Asli Demirguc-Kunt and Min Zhu, forthcoming, “How Does Deposit Insurance Affect Bank Risk? Evidence from the Recent Crisis” Journal of Banking and Finance.

Demirguc-Kunt, Asli, Ed Kane and Luc Laeven. Deposit Insurance around the World: Issues of Design and Implementation, Cambridge, MA: MIT Press, 2008.

Demirguc-Kunt, Asli, and Harry Huizinga. “Market Discipline and Deposit Insurance” Journal of Monetary Economics, Vol. 51(2), March 2004.

Demirguc-Kunt, Asli, and Enrica Detragiache. “Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation” Journal of Monetary Economics, Vol. 49(7), October 2002.

Demirguc-Kunt, Asli and Ed Kane. “Deposit Insurance Around the Globe: Where Does it Work?” Journal of Economic Perspectives, Vol. 16 (2), Spring 2002.

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