Government safety nets, banking system stability, and economic development

Abstract

The number, breadth, and cost of banking crises in developed and developing countries over the last fifteen years are unprecedented. While many factors contributed to the crises, the moral hazard associated with explicit and implicit government deposit insurance has been cited as a likely cause in a significant number of cases. A potential method for addressing moral hazard is to eliminate government deposit insurance programs and out law ex post government support for depositors. This option could lead to instability in the banking system and would likely lack the credibility needed to reduce moral hazard. Instead, deposit insurance reforms should balance the objectives of stability and moral hazard cost reduction. I propose a plan, with co-insurance at its core, to increase market discipline while minimizing any increase in instability. Enacting legal reforms that balance these competing goals is particularly important in developing countries, as the extent and quality of a country's financial infrastracture is a significant determinant of economic development.