Deposit Insurance and Financial Development

Abstract

Do deposit insurance programs contribute to financial development? Yes, but only if the regulatory environment is sound.

Cull, Senbet, and Sorge examine the effect of different design features of deposit insurance on long-run financial development, defined to include the level of financial activity, the stability of the banking sector, and the quality of resource allocation. Their empirical analysis is guided by recent theories of banking regulation that employ an agency framework.

The authors examine the effect of deposit insurance on the size and volatility of the financial sector in a sample of 58 countries. They find that generous deposit insurance leads to financial instability in lax regulatory environments. But in sound regulatory environments, deposit insurance does have the desired impact on financial development and growth.

Thus countries introducing a deposit insurance scheme need to ensure that it is accompanied by a sound regulatory framework. Otherwise, the scheme will likely lead to instability and deter financial development. In weak regulatory environments, policymakers should at least limit deposit insurance coverage.

This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to design financial safety nets for developing countries. The study was funded by the Bank's Research Support Budget under the research project "Deposit Insurance" (RPO 682-90). Robert Cull may be contacted at [e-mail].

JEL Classification: G2, O1, F3