Abstract - The Impact of Explicit Deposit Insurance on Market Discipline

This paper studies the impact of deposit insurance on market discipline in a setting 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 and that the degree to which deposit insurance affects market discipline depends on the coverage rate. Our results also suggest that most market discipline comes from large depositors and that the introduction of deposit insurance affects mainly large depositors who are active in the first place. 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, willing and able to perform this function.

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