Deposit Insurance and Financial Development

Abstract

This paper provides empirical evidence on the impact of deposit insurance on financial development and stability, broadly defined to include the level of banking activity and the stability of the banking sector. We use a unique dataset capturing a variety of deposit insurance features across countries, such as coverage, premium structure, etc. and synthesize available information by means of principal component indices. This paper is the first in this field of the literature to specifically address sample selection concerns by estimating a generalized Tobit model both via maximum likelihood and the Heckman 2-step method. The empirical construct is guided by recent theories of banking regulation that employ an agency framework. The basic moral hazard problem is the incentive for depository institutions to engage in excessively high-risk activities, relative to socially optimal outcomes, in order to increase the option value of their deposit insurance guarantee. The overall empirical evidence is consistent with the likelihood that generous government-funded deposit insurance might have a negative impact on financial development and growth in the long run, except in countries where the rule of law is well established and bank supervisors are granted sufficient discretion and independence from legal reprisals. Insurance premium requirements on member banks, even when risk-adjusted, are instead found to have little effect in restraining banks' risk-taking behavior.

Keywords: Deposit Insurance, Moral Hazard and Bank Supervision, financial development, bank regulation

JEL Classification: G2, O1, F3