Bank Moral Hazard and the Introduction of Official Deposit Insurance in Canada

Abstract

It has been long recognized that insured banks can exploit a mispriced risk-independent flat-rate deposit insurance (DI) system by increasing leverage (i.e., decreasing capital ratios) and/or asset risk. Such a behavior is known as moral hazard. There are, however, factors that can induce self-discipline by banks. For instance, charter value is one of such disciplining factors. The presence or absence of moral hazard is, indeed, an empirical issue to be tested in Canada, where DI was first implemented in 1967. This unique event has enabled us to analyze the risk-taking behavior of Canadian commercial banks following the introduction of flat-rate DI. Our results fail to detect the presence of moral hazard in the Canadian banking industry following the introduction of flat-rate DI. We find that the total risk of equity, the market risk, and the implicit volatility of banks' assets increased. Capital ratios also decreased, mainly in book values. However, we find that these manifestations, while necessary for the presence of moral hazard, are not sufficient conditions for inducing risk-shifting from banks to the Canada Deposit Insurance Corporation (CDIC). In fact, Canadian chartered banks have adjusted their capitalization in function of their asset risk.