Market Discipline and Financial Safety Net Design

Abstract

An important question is whether the financial safety net reduces market discipline on bank risk taking. For countries with varying deposit insurance schemes, we find that deposit rates continue to reflect bank riskiness. Cross-country evidence suggests that explicit deposit insurance reduces required deposit interest rates at a cost of reduced market discipline. Internationally, deposit insurance schemes vary widely in their coverage, funding, and management. Hence, there are widely differing views on how deposit insurance should optimally be structured. To inform this debate, we use a newly constructed data set of deposit insurance design features to examine how different design features affect deposit interest rates and market discipline.

JEL Classification: E43, G28