The Impact of Explicit Deposit Insurance on Market Discipline

V. Ioannidou, J. de Dreu

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Abstract

This paper studies the impact of explicit deposit insurance on market discipline in a framework that resembles a natural experiment.We improve upon previous studies by exploiting a unique combination of country-specific circumstances, design features, and data availability that allows us to distinguish between demand and supply effects.We show that deposit insurance causes a significant reduction in market discipline.We also show that the effect of deposit insurance depends on the coverage rate.When the coverage rate is more than 60 percent, market discipline is significantly reduced and it is completely eliminated when the coverage rate reaches 100 percent.Our results also suggest that most market discipline comes from large depositors and that the introduction of deposit insurance affected mainly those who were already active in imposing discipline.Our findings emphasize the need for binding coverage limits per depositor, high degrees of co-insurance, and "tailor made" deposit insurance systems that preserve the incentives of a critical mass of depositors that are willing and able to perform this function.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages41
Volume2006-5
Publication statusPublished - 2006

Publication series

NameCentER Discussion Paper
Volume2006-5

Keywords

  • market discipline
  • deposit insurance
  • deposit insurance coverage

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    Ioannidou, V., & de Dreu, J. (2006). The Impact of Explicit Deposit Insurance on Market Discipline. (CentER Discussion Paper; Vol. 2006-5). Finance.