Does Deposit Insurance Increase Moral Hazard in Banks? The Case of the Australian Financial Claims Scheme

Abstract

In this paper we analyze the relation between deposit insurance, bank risk and bank stability.Although there is a voluminous literature on the impact of deposit insurance on bank stability and bank risk, the consequences of deposit insurance remain controversial. In particular, deposit insurance is widely offered in a ever growing number of countries as part of a financial safety net to promote stability even if there is a wide empirical evidence relating to the failure of deposit insurance in maintaining banking stability because of the well known moral hazard problem.In order to study these relations we chose the particular case of the Australian "Financial Claims Scheme", because Australia was one of the few developed countries that did not have explicit deposit insurance facilities in place. With the growing uncertainty surrounding the health of the global financial markets in 2008, the Government decided to introduce protection for deposits and wholesale funding. So, deposit insurance measures were introduced not because of a serious threat to domestic stability of the banking system but mainly as a precautionary action to face deteriorating conditions in overseas financial markets.By using a probit regression model we found that in Australia the introduction of a deposit insurance scheme produced a decrease in the bank risk, that is banks are less risky than the period before. Results also demonstrate that the introduction of the scheme produced an increase in the bank stability and generalizing an increase in the stability of the Australian banking system as well.