NCPA - National Center for Policy Analysis

Deposit Insurance and Bank Stability

March 11, 2011

Many financial systems were plagued by bank runs or subject to the risk of contagion when the recent financial tsunami unfolded.  In response, policymakers and regulators in many countries have implemented various drastic regulatory measures to rescue the financial systems from meltdowns and to avert deep economic downturns.  Such measures vary from country to country, but they generally include government takeovers of banks or capital injections, quantitative easing techniques, provisions of liquidity by lax lender-of-last resort lending, lower discount rates and more generous deposit insurance, says Kam Ho Chu, an associate professor of economics at the Memorial University of Newfoundland.

By applying contingency table analysis to 52 countries over the period 1996-2007, the empirical results of this study show clearly that:

  • Low deposit insurance coverage outperforms both high and full coverage in maintaining banking stability.
  • The findings also suggest that the higher the deposit insurance coverage, the more severe the banking crisis is.
  • Higher coverage tends to undermine market discipline and aggravate the moral hazard problem associated with deposit insurance.
  • The recent measures or proposals in many countries to raise deposit insurance coverage or even to offer full coverage should not be espoused.
  • As a matter of political expedience, they are imposed by governments as temporary measures to curb bank runs and to alleviate the sharp pains due to the financial tsunami.
  • Their effectiveness in promoting banking stability in the long term should not be taken for granted.

More important, higher or full deposit insurance coverage is incompatible with the Basel II regulatory framework that consists of three pillars -- capital adequacy, supervisory review process and market discipline -- because excessive coverage undermines market discipline.  Needless to say, a three-legged stool is bound to collapse when one of its legs is weakened, says Chu.

Source: Kam Hon Chu, "Deposit Insurance and Banking Stability," Cato Journal, Winter 2011.

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