Deposit insurance is first introduced in the US in 1934 and then spread to all over the world in the late 1970s and early 1980s, aiming to prevent bank-runs that were contributed to the Great Depression in 1929-1933, from which increase bank stability. However, the merits of deposit insurance consists much of controversy: On the one hand, this prevents bank runs to the extent that banks would be compensated by the insurers if they face failures. On the other hand, banks will take more risky projects to get higher returns without tightly control of depositors (no market discipline imposed by depositors), which is called as moral hazard.
This paper, by theoretical and empirical approach, will solve the problem that whether market discipline can cope with moral hazard effects in deposit insurance systems or not. The first section will indicate the role of market discipline in deposit insurance systems with a theoretical point of view; The second section will analyse some empirical researches that contribute to providing the answer for the foregoing question. The third section concludes.
Market discipline, through interest rate, plays an important role in preventing bank risk taking which is one of the causes of bank failures and banking crises. The mechanism of market discipline is that when banks want to take high-risk, high-return projects, depositors will withdraw their money from those banks, or will demand higher interest rate for the risk that their funds may have taken. (Asli Demirguc-Kunt and Harry Huizinga (2003)- market discipline and deposit insurance).
However, when deposit insurance systems were officially introduced, the role of market discipline was affected to the extent that it has to face with moral hazard, which is the undesired consequence of financial safety net. The ability of banks to attract deposits is not influenced by the risks that they take; therefore, more bank failures are inevitable results. In addition, in the case risks are correlated, banking crises may become systemically, and the collapse of whole financial system may occur. (Asli Demirguc-Kunt and Enrica Detragiache (2000)- does deposit insurance increase bank stability). Nevertheless, some economists have found that we can design optimal systems that still enable market discipline and help increasing financial stability. Edward J.Kane (2000) indicates three ways to prevent bank risk taking lifting in deposit insurance systems. The first is combining the public deposit insurance systems with "private parties" (private deposit insurance) by imposing on these parties the responsibility to bear one part of losses in the event of banking crises, which contributes to operate market discipline. Because the parties do not want loss, they will be enforced to follow activities of banks and restrain banks from taking more risk. To do so, Government may let the private parties administer some parts of deposit insurance system or even all the system.
The second way to limit banks shifting risk taking is maintaining an incomplete deposit insurance coverage, which would force both banks and depositors to be more responsible with asset portfolios due to the reason that they still have to bear losses if bank fails.
The third way is to apply co-insurance policy in which depositors, by a contract, will absorb a share of losses in the situation that their banks get failures. This would effectively enable market discipline: depositors must tightly follow the investment process of their funds in banks, thus prevent banks risk taking increase.
Charles W.Calomiris (1997) also analysed negative impacts of deposit insurance (moral hazard � banks increase risk-taking) and reached quite similar solution for this problem: the requirement of collateral debt financing which makes private subordinated debt holders to take the responsibility on the risk and investment choices of banks. If information asymmetric is a matter that prevent Government from controlling banks risk taking activities through increasing insurance premium (Graph1), subordinated debt holders are sophisticated and skilled agents who face the danger of losing their own money leading to the result that they are intensive to follow the condition and activities of banks.
After considering the theoretical side, I will consider some empirical proof for two foregoing matters: The first is deposit insurance in general could cause bank frangibility, and the second is in some particular cases, with reasonable design of deposit insurance system, market discipline still has the ability to cope with moral hazard and raise banking stability.
To prove these matters, I use the result of research from Asl Demigruc-Kun and Enrica Detragiache (2000) carried on 61 countries in 1980-1997 period (data collected from the World Bank). The characteristics of deposit insurance designs in the 61 countries are described in Table 1, including co-insurance, coverage-limit, foreign currency deposits covered, inter-bank deposit covered, bank premium of deposit/liabilities, management and membership. As can be seen in the table, there are 24 countries only have implicit deposit insurance system but the frequency of banking crises in these countries is likely less than in a large number of countries who apply explicit deposit insurance system with high level of insurance coverage and without coinsurance. Many countries set upper limit to coverage although it considerably differs among countries: for instance, El Salvado has coverage limit of only $4,720 while Italy $125,000 or Norway $260,800.
To test how deposit insurance systems in the 61 countries affect to bank stability, Asl Demigruc-Kun and Enrica Detragiache have used multivariate logit model to estimate the probability of banking failure and crises based on the selected variables. Table 2 shows the result of the regression when a dummy variable as deposit insurance is entered in the model: its coefficient is significant at confidence level of 8 %. This implies that deposit insurance raises banks instability and banking failures. Table 3 indicates the result of regression in which the effect of deposit insurance dummy variable on bank stability varies among different level of insurance coverage. The higher degree of coverage, the more likely that deposit insurance system increases banks vulnerability. Therefore, limited insurance coverage could be one of the solutions to reduce banks failure caused by deposit insurance systems.
Another evident can be observed in Table 4 � Depositor Insurance Scheme in 1999 of 72 countries from Africa, Asia, Europe, Middle East and Western Hemisphere (Information collected by IMF). ("Deposit Insurance: A Survey of Actual and Best Practices"). Many countries prefer to insure more for small, less sophisticated depositors and to impose the responsibility on large depositors to control their banks' activities. As can be seen in the table, 10 deposit insurance system cover all type of deposits while most types are covered by the systems in 30 other countries, which means that there is an distinction in setting coverage levels between different kinds of deposits in almost countries considered. In addition, 20 of the schemes do not cover all foreign deposits and 7 deposit insurance systems in the EU countries also do not cover some deposits of non-EU currency. Because foreign deposits are usually of large and sophisticated depositors, it is clear that many countries do not want to protect this kind of depositors by excluding insurance coverage from them.
In the research of Gillian, 16 countries (UK, Portugal, Poland, Oman, Macedonia, Luxembourg, Lithuania, Ireland, Gibraltar, Germany, Estonia, Dominican Republic, Czech Republic, Colombia, Chile and Austria) also apply co-insurance in their deposit insurance systems to reach two goals: constrain moral hazard and avoid systematic bank runs. In these countries' schemes, depositors must bear a small percentage of the coverage which contributes to decrease effects of moral hazard and prevent systematic bank runs.
From the summary of theoretical and empirical research above, I come to the conclusion that although deposit insurance system, which is an important contribution in financial safety net of each country, can be the root cause of moral hazard but a good design of this scheme still leaves room for market discipline mechanism operation. In a deposit insurance system with high level of coverage and no co-insurance (deposits are fully insured by Governments), market discipline is likely unable to cope with moral hazard, banks have opportunity to take high risk for the high return, banking failures and more seriously, systematic financial crises become more often.
However, in an effective deposit insurance scheme, Governments do not cover all deposits but maintain a very low degree of insurance coverage with the preference to protect small depositors. Larger depositors, who have more sophisticated skills, would share one part of losses when banks fail which forces them to frequently control activities and investment choices of their banks, therefore, reducing bank crises. That is the reason why deposit insurance systems are being applied broadly in almost countries in the world.
 Graph 1 is the function of default risk subject to asset risk and leverage in which whenever banks increase risk taking from point A to point B, Government just need to increase the insurance premium by ten basic points to constrain bank risk taking increase.
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