Market Discipline and Financial Safety Net Design

Abstract

It is difficult to design and implement an effective safety net for banks, because overgenerous protection of banks may introduce a risk-enhancing moral hazard and destabilize the very system it is meant to protect. The safety net that policymakers design must provide the right mix of market and regulatory discipline - enough to protect depositors without unduly undermining market discipline on banks.

There has been little empirical work on the effectiveness of safety nets designed for banks, for lack of data on safety net design across countries. Demirgüç-Kunt and Huizinga examine cross-country data on bank-level interest expense and deposit growth for evidence of market discipline in individual countries. In addition, using cross-country information on deposit insurance systems, they investigate the impact of explicit deposit insurance (and its key features) on bank interest rates and market discipline.

They find that: · Many countries retain some degree of market discipline, regardless of the type of safety net. · The existence of explicit deposit insurance lowers banks' interest expenses and makes interest payments less sensitive to bank risk factors, especially bank liquidity. · Higher explicit coverage, broader coverage, and the existence of an earmarked insurance fund increase required-deposit rates and reduce market discipline. · Government provision of funds lowers deposit rates but also reduces market discipline. · Private (especially joint) management of insurance schemes lowers deposit rates and improves market discipline.

This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to study deposit insurance. The authors may be contacted at [e-mail] or [e-mail].