Deposit Insurance, Bank Runs, and Moral Hazard

Deposit insurance has been widely adopted to promote stability in the banking sector and has long been part of best practice recommendations by international organizations to developing countries. Over 80 percent of high-income countries have some sort of explicit deposit insurance in place, and the proportion of low-income countries with explicit deposit insurance has more than tripled in recent years. However, it is now well established in the academic literature that while deposit insurance may ensure depositor confidence and prevent bank runs, it also comes with an unintended consequence of encouraging banks to take on excessive risk. 

In March 2023 deposit insurance again became a topic of policy discussion when Silicon Valley Bank, formerly the 16^th largest lender in the US, faced a massive depositor run and failed within two days. Soon after, Signature Bank, based in New York, also failed. By May 2023, another regional bank, First Republic Bank, was also seized and sold off by government regulators. These three banks alone were worth more in inflation-adjusted assets than the 25 banks that had collapsed in 2008. Their failures rekindled the debate on the desirability of unlimited deposit insurance, and whether making full coverage explicit would be more effective in ensuring financial stability or lead to riskier behavior by banks.

In a new working paper, we review the literature on deposit insurance. We start with the theoretical underpinnings of deposit insurance and market discipline, present a brief history of how deposit insurance schemes started and spread around the world, and discuss the economic benefits and costs of deposit insurance and the empirical evidence of its impact. We conclude with a discussion of the importance of design and implementation in ensuring deposit insurance systems promote stability and perform their role in the overall financial safety net provided to the banking sector.

Deposit insurance and risk-taking

Banks are uniquely prone to runs because of the role they play in the economy in transforming short-term demand deposits into long-term assets. This maturity mismatch is inherently unstable. In addition to causing individual banks to fail, bank runs can have a ripple effect and trigger full-blown contagion. Fears about the insolvency of one bank can spread into a generalized contagion causing multiple banks to fail. A large number of bank failures can cause serious disruptions to a country’s economic activities and result in significant social and fiscal costs. Given the significant costs associated with banking crisis, deposit insurance, to the extent that it prevents contagious runs, can be highly valuable.

Deposit insurance guarantees that depositors will get their money back should their bank fail. This assurance brings confidence to the market, but at the same time distorts incentives of both bank managers and depositors, resulting in the well-known economic problem of moral hazard. Hence, deposit insurance has the benefit of preventing bank runs, but it also reduces the incentives of depositors to monitor banks. This results in excessive risk-taking. The excessive risk taking tends to be particularly problematic when complementary institutions such as regulation and supervision are weak, raising concerns about the popularity of deposit insurance in lower income countries.

Designing deposit insurance to reduce risk

The extensive empirical literature we review in the paper points out the importance of design features and shows that poorly designed schemes, instead of preventing runs, can increase the likelihood that a country will experience a banking crisis. Therefore, it is important for deposit insurance schemes to incorporate features to help internalize risk-taking by banks, such as limited coverage and risk-adjusted premiums. In addition to the specific design features, deposit insurance that is complemented by more stringent capital regulations and a system in which supervisors are empowered to take prompt corrective action, tends to function more effectively in practice. It is also important for countries to cultivate an environment in which private market participants such as large uninsured depositors, shareholders, and other creditors have the right set of incentives to monitor the banks they invest in. Most importantly, both public and private monitoring can only be effective in countries that have strong institutions and rule of law. In countries that lack strong institutional environments, explicit deposit insurance can end up doing more harm than good in terms of improving financial stability. 

The impact of deposit insurance can be unpredictable. Whether it benefits or harms a country depends on how well it is designed and administered. With technological advances and increased digitalization, as depositors become more sensitive to price and risk, ensuring the stability of the banking system is likely to become even more challenging for bankers and regulators alike.