How does deposit insurance affect bank stability? This is a question that has been around for a while but has come up again after the global financial crisis. In response to the crisis, a number of countries substantially increased the coverage of their safety nets in order to restore market confidence and to avert potential contagious runs on their banking sectors. Critiques worry that such actions are likely to further undermine market discipline, causing more instability down the line. My earlier research on this issue suggests that on average deposit insurance can exacerbate moral hazard problems in bank lending, making systems more fragile. In other words, particularly in institutionally under-developed countries, banks have a tendency to exploit the availability of insured deposits and increase their risk, making the financial system more crises prone. This is ironic since deposit insurance is supposed to make the systems more stable, not less.
But what if the impact of deposit insurance on stability varies depending on the economic conditions? Does deposit insurance help stabilize banking systems by enhancing depositor confidence during turbulent times?
- Financial Sector