The Role of Deposit Insurance in Liquidity Risk Management: Evidence from Systematic Banking Crises

Abstract

Customer deposits have traditionally been viewed as the primary source of liquidity risk facing banks. However, research over the past decade suggests that customer deposits can hedge the liquidity risk, stemming from unused loan commitments, since the liquidity demands of depositors and borrowers are not perfectly correlated. We argue in this paper that this complementarity between the simultaneous provision of liquidity to depositors and borrowers is only possible in the presence of deposit insurance. Accordingly, we use IMF-defined episodes of banking crises over the last 25 years as shocks to market liquidity to identify the impact of deposit insurance on bank lending during crises. The results suggest that there is significant positive relation between continued loan growth during crises and whether banks have access to deposit insurance. Further, this effect is concentrated in banks, relying more on core deposit funding.