Deposit Insurance, Moral Hazard and Market Monitoring

49 Pages Posted: 19 May 2004

See all articles by Reint Gropp

Reint Gropp

Halle Institute for Economic Research

Jukka M. Vesala

Bank of Finland - Finnish Financial Supervision Authority (FIN-FSA)

Date Written: February 2004

Abstract

The paper analyses the relationship between deposit insurance, debt-holder monitoring, and risk taking. In a stylised banking model we show that deposit insurance may reduce moral hazard, if deposit insurance credibly leaves out non-deposit creditors. Testing the model using EU bank level data yields evidence consistent with the model, suggesting that explicit deposit insurance may serve as a commitment device to limit the safety net and permit monitoring by uninsured subordinated debt holders. We further find that credible limits to the safety net reduce risk taking of smaller banks with low charter values and sizeable subordinated debt shares only. However, we also find that the introduction of explicit deposit insurance tends to increase the share of insured deposits in banks' liabilities.

Suggested Citation

Gropp, Reint and Vesala, Jukka, Deposit Insurance, Moral Hazard and Market Monitoring (February 2004). Available at SSRN: https://ssrn.com/abstract=299403

Reint Gropp (Contact Author)

Halle Institute for Economic Research ( email )

P.O. Box 11 03 61
Kleine Maerkerstrasse 8
D-06017 Halle, 06108
Germany

Jukka Vesala

Bank of Finland - Finnish Financial Supervision Authority (FIN-FSA) ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

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