Deposit Insurance and Bank Risk Taking

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.