How do regulatory ability and bank competition affect the adoption of explicit deposit insurance scheme and banks’ risk-taking behavior?

Abstract

In this study, we investigates how regulatory ability and bank competition affect the adoption of explicit deposit insurance scheme (eDIS) and banks' risk taking behavior under the scheme. We build a regulator-bank dynamic game model to explain why the implicit deposit insurance scheme is not the optimal choice when the regulator's regulatory ability is high. We also find that excessive competition makes banks take extreme risk and in such case eDIS is ineffective in preventing the occurrence of banking crises. Otherwise, eDIS can prevent the occurrence of banking crises effectively although banks take excessive risk under the scheme. Our model identifies that the effects of bank competition and regulatory ability on the banks' risk incentives created by eDIS are interdependent. Empirical analysis on 190 countries worldwide confirms that: (1) higher regulatory ability increases the probability of eDIS adoption. (2) Under the eDIS, less bank competition and higher regulatory ability could reduce the risk of banking during normal times. In addition, increased regulatory ability significantly weakens the positive effect of banking competition on banking risk. (3) Under the eDIS, more bank competition increases the probability of banking crisis occurrence.