Deposit Insurance and Market Discipline

Abstract

Limited coverage is a standard feature in deposit insurance schemes. It is used to limit moral hazard, and achieves this objective by reinforcing market discipline: depositors have more incentives to monitor banks’ risk-taking if they have skin in the game. In this paper, I study market discipline and coverage levels by analyzing the relationship of funding costs and deposit growth with banks’ leverage, non-performing loans and profitability. I use a database of Colombian banks’ balance sheets and take advantage of a sudden, significant, and exogenous increase in the coverage level that occurred in 2017. I find evidence of market discipline throughout the period of analysis, and there is no indication that it was reduced by the change in the coverage level. The results vary, however, when I look at specific groups of banks separately. Market discipline is no longer present when analyzing only big banks. Too-big-to-fail perceptions seem to limit it. This is also the case for banks concentrated in insured deposits, where limited coverage has a less prevalent role. Finally, in banks that rely more heavily on uninsured deposits, there is evidence of market discipline, and the data show that it was reduced when coverage increased.