Deposit Insurance and Bank Risk-Taking: Evidence from Internal Loan Ratings

Abstract

We analyze the effect of deposit insurance on the risk-taking behavior of banks in the context of a quasi-natural experiment using detailed credit registry data. Using the case of an emerging economy, Bolivia, which introduced a deposit insurance system during the sample period, we compare the risk-taking behavior of banks before and after the introduction of this system. We find that in the post-deposit insurance period, banks are more likely to initiate riskier loans (i.e., loans with worse ratings at origination). These loans carry higher interest rates and are associated with worse ex-post performance. We also find that banks do not compensate for the extra risk by increasing collateral requirements or decreasing loan maturities. Additional results suggest that the increase in risk-taking is due to the drop in market discipline from large depositors and that differences between large (too-big-to-fail) and small banks diminished in the post-deposit insurance period.