Deposit insurance and moral hazard problem: the case of Turkish banking system

Abstract

We investigate the effect of full deposit insurance introduced in 1994 on the financial performance of Turkish commercial banks. We construct a model, under reasonable assumptions, with deposit insurance where banks undertake excessive risk – moral hazard risk. Empirical investigation using experimental design approach supports our moral hazard hypothesis. Our findings indicate that banks subject to the moral hazard behaviour show significant increases in foreign exchange position risk and deterioration in capital adequacy relative to their benchmark after introduction of full deposit insurance system. We relate this excessive risk-taking to the moral hazard behaviour by commercial banks. The research results indicate that complete deposit insurance system distorts the incentive structure of commercial banks and thus, prevents proper functioning of market discipline mechanism and leads to the taking excessive risk-taking.