How deposit insurance affects financial depth : a cross-country analysis

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How deposit insurance affects financial depth : a cross-country analysis, Volume 1

Author:	Cull, Robert;	Collection Title:	Policy, Research working paper ; no. WPS 1875
Date Stored:	1998/01/01	Document Date:	1998/01/31
Document Type:	Policy Research Working Paper	Language:	English
Major Sector:	Finance	Report Number:	WPS1875
Sub Sectors:	Financial Sector Development	SubTopics:	Financial Crisis Management & Restructuring; Payment Systems & Infrastructure; Banks & Banking Reform; Insurance & Risk Mitigation; Financial Intermediation; Insurance Law
Volume No:	1

Summary: Should we expect deposit insurance to have a positive effect on development of the financial sector? All insurance pools individual risks: premiums are paid into a fund from which losses are met. In most circumstances, a residual claimant to the fund (typically a private insurance company) loses money when losses exceed premiums. Claimants that underprice risk tend to go bankrupt. With most deposit insurance, however, the residual claimant is a government agency with very different incentives. If the premiums paid by member banks cannot cover current fund expenditures, the taxpayer makes up the shortfall. Facing little threat of insolvency, there is less incentive for administrative agencies to price risk accurately. In the United States, researchers have found that the combination of increasing competition in banking services and underpriced deposit insurance led to riskier banking portfolios without commensurate increases in bank capital. Deposit insurance may facilitate risk-taking, with negative consequences for the health of the financial system. On the positive side, insurance may give depositors increased confidence in the formal financial sector -- which may decrease the likelihood of bank runs and increase financial depth. Indeed, simple bivariate correlations between explicit insurance and financial depth are positive. But when one also controls for income and inflation, that relationship disappears -- in fact, the partial correlation between changes in subsequent financial depth and the adoption of explicit insurance is negative (and quite pronounced). Counterintuitive though it may be, that stylized fact may be partially explained by the political and economic factors that motivated the decision to establish an explicit scheme. The circumstances surrounding decisions about deposit insurance are associated with different movements in subsequent financial depth. Adopting explicit deposit insurance to counteract instability in the financial sector does not appear to solve the problem. The typical reaction to that type of decision has been negative, at least with regard to financial depth in the three years after the program's inception. Adopting explicit deposit insurance when government credibility and institutional development were high appears to have had a positive effect on financial depth.


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