FORUM Deposit Insurance Deniz Anginer and Ata Can Bertay As with other financial safety net measures, there is a natural economic trade-off associated with deposit Deposit Insurance Design and insurance. While it can enhance depositor confidence Institutional Environment and reduce the likelihood of bank runs during crisis periods, deposit insurance can also increase moral haz- ard and make financial systems more vulnerable to cri- ses during good times. From a public policy perspec- tive, it is essential to know the factors and design features that will enhance the stabilization effects of Deniz Anginer Deposit insurance is a widely used and integral part of deposit insurance while reducing the inevitable adverse The World Bank. the financial safety net provided by states across the effects. Recent literature suggests that deposit insur- globe. According to the Bank Regulation and Supervi- ance design and implementation can affect how well sion Survey (BRSS) conducted by the World Bank, over deposit insurance schemes perform in practice (see 107 countries have some form of explicit deposit insur- Anginer and Demirgüç-Kunt 2018 for a literature ance scheme in place as of 2016. This number has review). For instance, limiting coverage and scope and increased substantially from 93 in the year 2013. implementing risk-based pricing can help to alleviate During and after the global financial crisis (GFC), moral hazard problems and to internalize banks’ some countries introduced new deposit insurance risk-taking. schemes and others extended the scope and coverage The recent research also emphasizes the role that of their existing schemes to restore confidence in their the larger institutional environment plays in how effec- Ata Can Bertay banking systems. For instance, Australia and Singapore tive deposit insurance schemes are in practice as well The World Bank. introduced explicit deposit insurance to their banking as specific design features that are implemented. In systems for the first time, whereas Spain and the US particular, the research suggests that it is vital for coun- increased the limit on the amounts that are covered by tries to cultivate an environment that provides the right deposit insurance. Other countries increased the scope set of incentives for supervisors and regulators on the of securities and bank liabilities guaranteed. Most one hand, and private market participants (such as notably, Ireland extended deposit insurance to most large uninsured depositors, shareholders, and other bank liabilities, essentially offering a blanket guarantee creditors), on the other, to monitor the banks they on bonds, subordinated debt, and interbank deposits. invest in. Thus, strong institutions and the rule of law The significant expansion of explicit deposit insurance can be crucial for effective public and private monitor- during the crisis rekindled the debate about the effi- ing. In this short article, we discuss how the larger insti- cacy of deposit insurance schemes and the inevitable tutional environment affects the design, adoption, and moral hazard problems associated with providing state performance of deposit insurance schemes using the guarantees. results from the recent Bank Regulation and Supervi- A vast empirical literature established that deposit sion Survey (BRSS) conducted by the World Bank. insurance brings economic benefits by ensuring depos- In particular, we categorize economies into two itor confidence and preventing bank runs. At the same groups using a composite measure of institutional time, deposit insurance also comes with the unin- quality calculated as the average estimated index of six tended consequence of encouraging banks to take on indicators drawn from the World Governance Indica- excessive risk. This standard moral hazard problem tors. These capture various dimensions of institutional arises because deposit insurance distorts incentives quality such as accountability, political stability, gov- for bank managers, shareholders, and depositors. Bank ernment effectiveness, regulatory quality, rule of law, managers and shareholders are incentivized to take on and control of corruption. We compute the average higher risk, as they privately capture the upside returns institutional quality on a rolling basis for the years but do not internalize downside losses, which are 2005, 2010, and 2016, thus including both the pre- and socialized through the deposit insurance fund. By lim- post-GFC periods. Table 1 provides a list of countries iting downside risk, deposit insurance naturally incen- that are covered in the analyses. We classify countries tivizes greater risk-taking. Depositors also have less of as having high (above median) institutional quality if an incentive to be careful in the initial selection of their their composite institutional quality score is above the bank and monitoring its financial condition, as they are median of all countries in a given year. Likewise, coun- protected against losses when there is a bank failure. tries are classified as having low (below median) insti- ifo DICE Report I/ 2019 Volume 17 3 FORUM Figure 1 and economically developed countries, Dewenter, Hess, and Use of Explicit Deposit Insurance Brogaard (2018) examine how Above median institutions levels of economic freedom, Below median institutions rule of law, and corruption in % 90 82 82 a given bank’s home country 78 80 73 76 affect moral hazard. Even in a 70 set of institutionally compara- 63 60 ble countries, the authors find 50 that in most cases, better insti- tutions help mitigate problems 40 associated with deposit insur- 30 ance. Focusing on developing 20 countries, Cull, Senbet, and 10 Sorge (2004) show that in weak 0 institutional environments, 2005 2010 2016 deposit insurance reduces Note: The figure presents the percentage of countries with an explicit deposit insurance protection system for banks. Source: Authors’ calculations from BRSS and WGI (2019). © ifo Institute economic growth and financial development. More importantly, empiri- tutional quality if their composite score is below the cal evidence suggests that weak institutional environ- median. Countries highlighted in bold in Table A1 are ments can prevent optimal deposit insurance design. developing countries, indicating that income groups In particular, the rule of law and other private and pub- (i.e., high-income vs. developing countries) are not fully lic contracting environment features proved important capturing the institutional quality differences. in deposit insurance adoption and design (Demirgüç- Figure 1 shows how the explicit deposit insurance Kunt and Kane 2002; Hovakimian, Kane, and Laeven coverage evolved during the last decade for these two 2003). These, in turn, impact how well deposit insur- sets of countries. Explicit deposit insurance was quite ance schemes function in a given country. Key design extensive even before the GFC: 78% of countries with features are credible limited coverage, co-insurance, high-quality institutions had it in 2005, compared to and risk-based pricing. 63% of countries with low-quality institutions. After the Co-insurance systems, in which deposit insurance GFC, explicit deposit insurance became more common covers less than 100 percent of a depositor’s account across the world, and the adoption rate in low institu- balance, are one way to incentivize depositors to mon- tional quality countries almost caught up with that of itor banks and make more prudent bank choices in the high-quality institutions group in 2016. their deposit decision. Over the past decade, co-insur- Cross-country analyses of deposit insurance ance systems have been largely removed as it is now schemes show that in settings with low institutional believed that partial payments in the event of bank fail- quality, deposit insurance can be destabilizing and can ures can increase the likelihood of bank runs. Co-insur- have adverse consequences for market discipline. ance as a design element declined in both the high and Focusing on the rule of law plus the supervision and low institutional quality countries. In particular, the strength of the legal system, Demirgüç-Kunt and Detra- percentage of countries with high-quality institutions giache (2002) examine how various measures of institu- using some form of co-insurance was 38 percent in tional quality affect how well deposit insurance works 2005, and this percentage declined to eight percent by in different countries. They find that, on average, the 2016. In low institutional quality countries, the per- existence of explicit deposit insurance increases the centage likewise declined from 39 percent in 2005 to six probability that a country will experience a banking cri- percent in 2016. sis. However, using the institutional quality measures Charging banks risk-adjusted premiums for mentioned above, they find that the probability that deposit insurance coverage is another way to alleviate deposit insurance will result in a crisis is significantly moral hazard problems. The premiums charged to lower in countries with higher levels of institutional banks can either be a flat fee, or they can be based on quality. the risk a bank poses to the deposit insurance fund. Angkinand (2009) and Angkinand and Wihlborg Under such a system, banks with higher asset or loan (2010) analyze the impact of institutional variables such risk (and thus more likely to fail) would be charged as the rule of law, corruption, and shareholder rights on higher insurance fees. Risk-based pricing can