Deposit insurance: rationale, objectives and challenges

• Author: Dobkowitz, Sonja; Evrard, Johanne; Carmassi, Jacopo; Silva, André; Parisi, Laura; Wedow, Michael
• Pages: 8-9

ECB Occasional Paper Series No 208 / April 2018

8

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).