Deposit Insurance and Bank Risk Taking

Carolina Lopez-Quiles,Matic Petricek

doi:10.2139/ssrn.3158394

Abstract

This paper estimates the effect of deposit insurance on the risk-taking behaviour of banks. As shown in the theoretical literature, deposit insurance may induce moral hazard and incentivise banks to take on more risk. In this paper we provide an experimental setup in which we exploit an increase in the coverage limit of deposit insurance in the U.S. in order to identify the difference in risk taking by banks that were affected and banks that were not. This difference comes from the fact that state chartered savings banks in Massachusetts had unlimited deposit insurance coverage at the time when it was increased for all other banks in the US. Given that all banks in the sample are subject to the same regulatory and supervisory requirements, and that they are similar in other characteristics, we can isolate the effect of such increase in deposit insurance. We find, contrary to the literature, that this increase in deposit insurance did not increase bank risk-taking, nor did it affect market discipline, evident through a lack of an effect on deposit rates.

Highlights

Deposit insurance has been discussed extensively from a theoretical point of view
We find no significant effect of an increase in deposit insurance coverage on bank risk taking
Using an experimental setup and a measure of risk-taking that is based on new loans instead of balance sheet data, we find no significant effect of an increase of deposit insurance coverage limit on risk taking by banks

Summary

Introduction

Deposit insurance has been discussed extensively from a theoretical point of view. [Diamond and Dybvig, 1983] showed that deposit insurance can eliminate the risk of bank runs by ruling out the equilibrium where all depositors withdraw their deposits early. As shown by [Cooper and Ross, 2002], deposit insurance may bring about some social costs in the presence of moral hazard. Depositors do not have incentives to monitor banks, which may induce them to choose riskier portfolios in search for a higher return. [Demirguc-Kunt, 2002] provide some evidence that deposit insurance increases the likelihood of banking crises. As pointed out by [Anginer et al, 2014], this effect was different during the crisis, as they found that deposit insurance decreased bank risk-taking during this period. In another paper, [Ioannidou and Penas, 2010]

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