Deposit insurance: rationale, objectives and challenges

AuthorDobkowitz, Sonja; Evrard, Johanne; Carmassi, Jacopo; Silva, André; Parisi, Laura; Wedow, Michael
ECB Occasional Paper Series No 208 / April 2018
2 Deposit insurance: rationale, objectives
and challenges
The guiding rationale behind a deposit insurance scheme is to enhance financial
stability by increasing depositors’ confidence in the safeness of their deposits
(Diamond and Dybvig, 1983). By removing the depositors’ incentives to withdraw
their money when concerned about a bank’s solvency, deposit insurance ultimately
reduces liquidity risk which may in turn reduce the likelihood of financial crises and
their severeness. Bernet and Walter (2009) argue that a deposit insurance scheme
can also be seen as a means to strengthen the competitiveness of smaller banks, to
foster growth by encouraging savings, and to have banks financing the deposit
insurance thereby reducing costs otherwise borne by taxpayers or depositors in case
of a resolution or insolvency.
As documented by Demirgüç-Kunt et al. (2008), the number of countries with an
explicit deposit insurance system rapidly increased over the last few decades, from
twenty in 1980 to eighty-seven by the end of 2003. Therefore, already before the
2008 global financial crisis, deposit insurance had become a key tool of the financial
safety net. After the crisis, this trend was reinforced: Demirgüç-Kunt et al. (2014)
reported that, out of 189 countries covered in their 2013 updated deposit insurance
dataset, 112 countries (or 59%) had explicit deposit insurance by yearend 2013 while
there were 84 (or 44%) in 2003.8
The widespread adoption of explicit deposit insurance schemes around the world
signals a general belief that deposit insurance will bring benefits for depositor
protection and financial stability. However, deposit insurance schemes can also have
unintended consequences such as a shift in incentives towards risk-taking by banks
(moral hazard) and a decrease in effective monitoring exercised by depositors
(market discipline) (see, for example, Calomiris and Jaremski 2016a, 2016b).
Indeed, theory predicts that, once insured, there is a higher incentive for bankers to
enlarge the value of the deposit insurance by increasing risk (Merton, 1977). On the
depositor side, there is a lower incentive to search for the best bank to entrust their
savings or to demand higher interest rates in return for higher risk. For uninsured
deposits and where doubts on the credibility of the insurance arise, the economic
literature finds that banks’ risk is in fact reflected in their interest rates (e.g., Brewer
and Mondschean, 1994; Ellis and Flannery, 1992; Cook and Spellmann, 1994).
However, different conclusions emerge from Allen et al. (2017), who analyse the
effects of government guarantees on financial stability: the authors find that
guarantees are welfare improving since they induce banks to improve liquidity
8 Although all depos it insurance schemes share th e goal of protecting depositors' confidence and
financial stability, their key features differ across countries, as shown by Demirgüç-Kunt et al. (2008,
2014). Differences may relate, among other f eatures, to the coverage level, the source of funding of
deposit insura nce, the institutional arrangements, the coverage of foreign currency deposits and
interbank deposits, or the presence of a co-insurance mechanism (under which depositors are insured
only for a fraction of their insured deposits and thus retain a portion of the possible losses).

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