Deposit insurance and banking stability.

• Author: Chu, Kam Hon
• Position: Essay

Many financial systems were plagued by bank runs or subject to the risk of contagion when the recent financial tsunami unfolded. The runs on the U.S. banks Countrywide and IndyMac, Britain's Northern Rock, and Hong Kong's Bank of East Asia, among others, occurred about a few years ago, but they are still vivid to us. These runs were, of course, the symptoms rather than the root cause of the financial tsunami. In response to the most severe systemic global financial crisis since the Great Depression, policymakers and regulators in many countries have implemented various drastic regulatory measures to rescue the financial systems from meltdowns and to avert deep economic downturns. Such measures vary from country to country, but generally speaking they include governments' takeovers of banks or capital injections, quantitative easing techniques, provisions of liquidity by lax lender-of-last-resort lending, lower discount rates, and more generous deposit insurance.

In the case of deposit insurance, many countries have raised deposit insurance coverage while some even have provided full coverage in order to curb bank runs. For example, in October 2008, the U.S. Federal Deposit Insurance Corporation (FDIC) temporarily raised its coverage from $100,000 to $250,000, whereas the British government lifted the compensation ceiling on savings accounts from 35,000 [pounds sterling] to 50,000 [pounds sterling]. Following the passage of the Dodd-Frank Bill in

July 2010, the limit of deposit insurance coverage in the United States has now been permanently raised to $250,000. On the other hand, Hong Kong's Deposit Protection Scheme guarantees full repayment of all customer deposits until the end of 2010 as a temporary measure and will raise the coverage from the original HK$100,000 to HK$500,000 effective January 1, 2011. Other countries that have adopted full deposit guarantee as a temporary precautionary measure against financial turbulence include Germany, Indonesia, Ireland, Malaysia, and Singapore, to name just a few. Even countries like Australia and New Zealand where there were no explicit deposit insurance schemes before the financial tsunami have also jumped on the bandwagon to offer full deposit insurance coverage. On the surface, these measures of higher or full deposit insurance coverage have succeeded in containing bank runs, at least temporarily.

Following the historical $700 billion bailout plan by the U.S. federal government, there is a proliferation of comments on and analyses of causes of the financial tsunami and shortcomings of the rescue plan. (1) To make the task manageable, I focus on the relation between deposit insurance coverage and financial stability in this study. Although there is a voluminous literature on the impact of deposit insurance on banking stability and many closely related issues (for an excellent collection of the recent contributions, see Demirguc-Kunt, Kane, and Laeven 2008a), the desirability of deposit insurance remains controversial. Notwithstanding ample empirical evidence indicating the failure of deposit insurance in maintaining banking stability because of the notorious moral hazard problem (see, for example, Keeley 1990 for the United States, Carr, Mathewson, and Quigley 1995, and Wagster 2007 for Canada, and Demirguc-Kunt and Detragiache 2002 for a panel of 61 countries), the global trend of instituting explicit deposit insurance schemes keeps going under momentum (DemirgucKunt, Kane, and Laeven 2008a). Not only has the number of deposit insurance schemes gone up, but also the coverage is higher than before. Some studies justify the recent trend of higher coverage on the grounds that deposit insurance schemes with low coverage or partial coverage may be ineffective in preventing bank runs (e.g., Carse 2008, Schih 2008). The empirical support for this justification is, however, based mainly on the recent bank runs like the case of Northern Rock. This article will examine in a more systematic way the effectiveness of deposit insurance coverage in maintaining banking stability. More specifically, in the next section I argue that raising deposit insurance coverage in an attempt to eradicate bank runs is not necessarily the optimal policy because bank runs, though commonly perceived as instability when they take place, have their positive role to play in reinforcing banking stability in the longer run. Then I examine empirically the impact of higher deposit insurance coverage on promoting banking stability based on recently released cross-country databases. An explanation for the empirical results is given before the article concludes with the policy implication.

Deposit Insurance and Bank Runs

Most people, regulators in particular, view bank runs as bad and signs of financial instability because bank runs are costly and economically inefficient as they interrupt financial intermediation and hence adversely affect aggregate economic activity and growth. A major argument in favor of deposit insurance is that it maintains and promotes financial stability by preventing inefficient bank runs arising from asymmetric information and self-fulfilling prophecies (Diamond and Dybvig 1983). Simply put, depositors, small depositors in particular, have at best incomplete information about banks' financial conditions and hence they may run on their banks in anticipation of runs. Indeed, there is empirical evidence indicating that both good and bad banks are likely to suffer from massive deposit withdrawals during large-scale financial crises like the Great Depression (see Calomiris and Mason 1997, 2003 for details). More recently, Iyer and Puri (2008) show that the collapse of a major bank in India in 2001 triggered depositors to run on a solvent bank unrelated to the collapsed bank. Despite their finding of contagion, the authors conclude that deposit insurance is only partially effective in preventing bank runs and instead stronger and longer banker-depositor relationships may be more effectual. They also find that the damage of a bank run can be severe and long-lasting as the bank's overall deposit balance did not recover even six months after the run. While their findings will mostly be interpreted as bad effects of a bank run because it adversely affects the bank's profitability and interrupts financial intermediation, we will realize very shortly below that bank run actually has good effects as well.

The above findings are, however, unlikely to settle the controversy on whether bank runs are panic-driven and contagious because some studies, both theoretical and empirical, indicate that bank runs are information-based and related to economic outlooks or business cycles (e.g., Chari and Jagannathan 1988 and Gorton 1988). While the possibility of contagious runs cannot be entirely ruled out, the bad effects of bank runs are sometimes exaggerated. Historical evidence indicates that bank contagions are not widespread or long-lasting, at least in the United States (Kanfman 2000) and Canada (Carr, Mathewson, and Quigley 1995). On the contrary, a good effect of bank runs--strong market discipline on banks to maintain prudence and to avoid bank failures--is usually understated or even overlooked, particularly by regulators. From this perspective, the potential of bank runs can be efficient in maintaining banking stability.

It is important to recognize both the bad and good effects of bank runs and to distinguish between a run on an individual bank and a system-wide run (Kaufman 1996). As long as a run is on an individual bank but not on the banking system as a whole, deposits are just redistributed from the bank that is perceived by depositors as more risky, and hence run on, to other safer and financially sound banks. In this case, the run helps to drive out the economically insolvent or ill-managed bank, thus maintaining a financially healthy banking system. Although bank runs are socially costly as they interrupt financial intermediation, the potential of bank runs has a social benefit as it provides incentives for prudential and good banking practices. No bank likes runs because they blemish its reputation and harm its long-term profitability. Unfortunately, regulators often fail, deliberately or not, to recognize the above distinction in their practice and they tend to implement policies, such as deposit insurance, that aim at eradicating bank runs. Their policy decisions may not necessarily be in the best interest of society because regulators have their own career objectives as well (Kane 1990).

Let us consider the latest bank run in Hong Kong as an example to illustrate the above ideas. The Hong Kong ease is highly relevant and should have policy implications for regulators in other countries as well. First, Hong Kong offers full deposit insurance coverage as a temporary measure to alleviate the adverse impact of the financial tsunami. Second, it will accept the proposal to raise its coverage when the current temporary measure expires by the end of 2010 (Carse 2008). For regulators in Hong Kong, there is an additional reason to regard bank runs as bad and to eliminate them because they are deemed to tarnish Hong Kong's image and jeopardize its status as an international financial...