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FORUM
Deposit Insurance
Deniz Anginer and Ata Can Bertay As with other financial safety net measures, there
is a natural economic trade-off associated with deposit
Deposit Insurance Design and insurance. While it can enhance depositor confidence
Institutional Environment and reduce the likelihood of bank runs during crisis
periods, deposit insurance can also increase moral haz-
ard and make financial systems more vulnerable to cri-
ses during good times. From a public policy perspec-
tive, it is essential to know the factors and design
features that will enhance the stabilization effects of Deniz Anginer
Deposit insurance is a widely used and integral part of deposit insurance while reducing the inevitable adverse The World Bank.
the financial safety net provided by states across the effects. Recent literature suggests that deposit insur-
globe. According to the Bank Regulation and Supervi- ance design and implementation can affect how well
sion Survey (BRSS) conducted by the World Bank, over deposit insurance schemes perform in practice (see
107 countries have some form of explicit deposit insur- Anginer and Demirgüç-Kunt 2018 for a literature
ance scheme in place as of 2016. This number has review). For instance, limiting coverage and scope and
increased substantially from 93 in the year 2013. implementing risk-based pricing can help to alleviate
During and after the global financial crisis (GFC), moral hazard problems and to internalize banks’
some countries introduced new deposit insurance risk-taking.
schemes and others extended the scope and coverage The recent research also emphasizes the role that
of their existing schemes to restore confidence in their the larger institutional environment plays in how effec- Ata Can Bertay
banking systems. For instance, Australia and Singapore tive deposit insurance schemes are in practice as well The World Bank.
introduced explicit deposit insurance to their banking as specific design features that are implemented. In
systems for the first time, whereas Spain and the US particular, the research suggests that it is vital for coun-
increased the limit on the amounts that are covered by tries to cultivate an environment that provides the right
deposit insurance. Other countries increased the scope set of incentives for supervisors and regulators on the
of securities and bank liabilities guaranteed. Most one hand, and private market participants (such as
notably, Ireland extended deposit insurance to most large uninsured depositors, shareholders, and other
bank liabilities, essentially offering a blanket guarantee creditors), on the other, to monitor the banks they
on bonds, subordinated debt, and interbank deposits. invest in. Thus, strong institutions and the rule of law
The significant expansion of explicit deposit insurance can be crucial for effective public and private monitor-
during the crisis rekindled the debate about the effi- ing. In this short article, we discuss how the larger insti-
cacy of deposit insurance schemes and the inevitable tutional environment affects the design, adoption, and
moral hazard problems associated with providing state performance of deposit insurance schemes using the
guarantees. results from the recent Bank Regulation and Supervi-
A vast empirical literature established that deposit sion Survey (BRSS) conducted by the World Bank.
insurance brings economic benefits by ensuring depos- In particular, we categorize economies into two
itor confidence and preventing bank runs. At the same groups using a composite measure of institutional
time, deposit insurance also comes with the unin- quality calculated as the average estimated index of six
tended consequence of encouraging banks to take on indicators drawn from the World Governance Indica-
excessive risk. This standard moral hazard problem tors. These capture various dimensions of institutional
arises because deposit insurance distorts incentives quality such as accountability, political stability, gov-
for bank managers, shareholders, and depositors. Bank ernment effectiveness, regulatory quality, rule of law,
managers and shareholders are incentivized to take on and control of corruption. We compute the average
higher risk, as they privately capture the upside returns institutional quality on a rolling basis for the years
but do not internalize downside losses, which are 2005, 2010, and 2016, thus including both the pre- and
socialized through the deposit insurance fund. By lim- post-GFC periods. Table 1 provides a list of countries
iting downside risk, deposit insurance naturally incen- that are covered in the analyses. We classify countries
tivizes greater risk-taking. Depositors also have less of as having high (above median) institutional quality if
an incentive to be careful in the initial selection of their their composite institutional quality score is above the
bank and monitoring its financial condition, as they are median of all countries in a given year. Likewise, coun-
protected against losses when there is a bank failure. tries are classified as having low (below median) insti-
ifo DICE Report I/ 2019 Volume 17 3FORUM
Figure 1 and economically developed
countries, Dewenter, Hess, and
Use of Explicit Deposit Insurance
Brogaard (2018) examine how
Above median institutions levels of economic freedom,
Below median institutions rule of law, and corruption in
%
90
82 82
a given bank’s home country
80 78 76 affect moral hazard. Even in a
73
70 set of institutionally compara-
63
60 ble countries, the authors find
50 that in most cases, better insti-
tutions help mitigate problems
40
associated with deposit insur-
30
ance. Focusing on developing
20
countries, Cull, Senbet, and
10
Sorge (2004) show that in weak
0 institutional environments,
2005 2010 2016
deposit insurance reduces
Note: The figure presents the percentage of countries with an explicit deposit insurance protection system for banks.
Source: Authors’ calculations from BRSS and WGI (2019). © ifo Institute economic growth and financial
development.
More importantly, empiri-
tutional quality if their composite score is below the cal evidence suggests that weak institutional environ-
median. Countries highlighted in bold in Table A1 are ments can prevent optimal deposit insurance design.
developing countries, indicating that income groups In particular, the rule of law and other private and pub-
(i.e., high-income vs. developing countries) are not fully lic contracting environment features proved important
capturing the institutional quality differences. in deposit insurance adoption and design (Demirgüç-
Figure 1 shows how the explicit deposit insurance Kunt and Kane 2002; Hovakimian, Kane, and Laeven
coverage evolved during the last decade for these two 2003). These, in turn, impact how well deposit insur-
sets of countries. Explicit deposit insurance was quite ance schemes function in a given country. Key design
extensive even before the GFC: 78% of countries with features are credible limited coverage, co-insurance,
high-quality institutions had it in 2005, compared to and risk-based pricing.
63% of countries with low-quality institutions. After the Co-insurance systems, in which deposit insurance
GFC, explicit deposit insurance became more common covers less than 100 percent of a depositor’s account
across the world, and the adoption rate in low institu- balance, are one way to incentivize depositors to mon-
tional quality countries almost caught up with that of itor banks and make more prudent bank choices in
the high-quality institutions group in 2016. their deposit decision. Over the past decade, co-insur-
Cross-country analyses of deposit insurance ance systems have been largely removed as it is now
schemes show that in settings with low institutional believed that partial payments in the event of bank fail-
quality, deposit insurance can be destabilizing and can ures can increase the likelihood of bank runs. Co-insur-
have adverse consequences for market discipline. ance as a design element declined in both the high and
Focusing on the rule of law plus the supervision and low institutional quality countries. In particular, the
strength of the legal system, Demirgüç-Kunt and Detra- percentage of countries with high-quality institutions
giache (2002) examine how various measures of institu- using some form of co-insurance was 38 percent in
tional quality affect how well deposit insurance works 2005, and this percentage declined to eight percent by
in different countries. They find that, on average, the 2016. In low institutional quality countries, the per-
existence of explicit deposit insurance increases the centage likewise declined from 39 percent in 2005 to six
probability that a country will experience a banking cri- percent in 2016.
sis. However, using the institutional quality measures Charging banks risk-adjusted premiums for
mentioned above, they find that the probability that deposit insurance coverage is another way to alleviate
deposit insurance will result in a crisis is significantly moral hazard problems. The premiums charged to
lower in countries with higher levels of institutional banks can either be a flat fee, or they can be based on
quality. the risk a bank poses to the deposit insurance fund.
Angkinand (2009) and Angkinand and Wihlborg Under such a system, banks with higher asset or loan
(2010) analyze the impact of institutional variables such risk (and thus more likely to fail) would be charged
as the rule of law, corruption, and shareholder rights on higher insurance fees. Risk-based pricing can help
the relationship between deposit insurance and finan- internalize the cost of risk-taking by bank managers
cial stability. The authors find that institutional envi- and shareholders, which in turn would curb the exces-
ronments that incentivize effective public and private sive risk-taking that results from moral hazard.
monitoring can alleviate moral hazard effects associ- Although there are issues related to figuring out the
ated with deposit insurance. Focusing on financially actuarially fair value of fees, the empirical evidence
4 ifo DICE Report I/ 2019 Spring Volume 17FORUM
shows that risk-adjusted pre- Figure 2
miums perform better than Use of Risk-Based Premiums
flat-rate premiums in reducing
Above median institutions
bank risk (Demirgüç-Kunt and
Below median institutions
Detragiache 2002; Hovakimian, %
90
Kane, and Laeven 2003).
80
Risk-based pricing was ini-
70
tially pioneered in the US in the
60
early 1990s and quickly spread
to other countries. In 1997, only 50
four countries (Finland, Peru, 40
Sweden, and the US) used risk- 30
based pricing for deposit insur- 20
ance fees (Demirgüç-Kunt and 10
Huizinga, 1999). As of 2016, this 0
2005 2010 2016
number has increased to 55.
Note: The figure presents countries, in which deposit insurance fees/premiums charged to banks vary based on some
Figure 2 shows that use of risk- assessment of risk.
based premiums for deposit Source: Authors’ calculations from BRSS and WGI (2019). © ifo Institute
insurance in high institutional
quality countries has increased Figure 3
substantially in recent years.
Deposit Insurance Funding
As of 2016, 83 percent of coun-
tries in this group reported Accumulated funds over total insured deposits (%)
10
charging premiums based on
9
risk. Although there has been
8
an increase in the low institu-
7
tional quality group, it is still 6
well below the high institu- 5
tional quality countries: only 4
38 percent in 2016. 3
Implementing credible 2
limited coverage ex ante is 1
another crucial design fac- 0
tor for deposit insurance to -1,5 -1 -0,5 0 0,5 1 1,5 2
Institutional quality
work effectively. In theoretical
models of deposit insurance, Note: The figure presents how the ratio of accumulated funds to total insured deposits is correlated with the
institutional quality index in 2016.
bank runs happen as a result Source: Authors’ calculations from BRSS and WGI (2019). © ifo Institute
of self-fulfilling phenomena
(see, for instance, Diamond
and Dybvig 1983 and extensions). Lack of confidence The recent experiences with deposit insurance in
in the banks causes investors to rush to be the first in Cyprus and Iceland illustrate the importance of ade-
line to withdraw their funds. If depositors believe that quate funding for deposit insurance for it to be credi-
other investors will not run, then only investors with ble. In a sense, all insurance schemes are underfunded,
real liquidity needs withdraw their funds. The bank as it is impossible to have funds in place to fully cover
can meet these demands without costly liquidation of all potential losses of depositors. Yet depositors expect
assets. Nevertheless, if everyone believes that a run the government to step in during a crisis and provide a
will occur, then it becomes a self-fulfilling prophecy as full backstop. However, this type of intervention
depositors run to avoid being last in line. The bank is requires the government to have the political will—and
then forced to liquidate its long-term assets in a costly more importantly, the economic resources—to do so.
way. This results in unnecessary economic losses as an In countries where the institutions have deteriorating
otherwise solvent bank is forced to liquidate. In these and poorly governed finances, intervention is not
models, the effectiveness of deposit insurance relies always a viable option, and underfunding can be a real
heavily on depositors’ confidence that the insurance is possibility. These countries tend to also suffer from
credible. Even if there is a small chance that the deposit political instability, and it may be challenging to bring
insurance scheme will run out of funds, then it is different stakeholders together to agree on providing
rational for depositors to run to the bank and withdraw funds to a dispersed group of depositors.
their funds. Thus, deposit insurance schemes must be In theoretical models, the economic cost of
credible ex ante in order to stop contagious runs (Bon- deposit insurance is zero, since deposit insurance elim-
fim and Santos 2017; Calomiris and Powell 2001). inates an equilibrium in which everyone runs. If deposit
ifo DICE Report I/ 2019 Volume 17 5FORUM
insurance is credible and depositors do not run, then ance funding ratio in the univariate analysis. We also
taxes do not have to be imposed ex ante to fund the find that deposit insurance coverage indexation (with
deposit insurance scheme. However, as credibility can respect to, for example, prices or per capita GDP) is
be an issue in low institutional quality countries, much more common in low institutional quality coun-
deposit insurance schemes have to be sufficiently tries. In 2016, 44 percent of the countries in the low
funded to assure depositors that there will be resources institutional quality group had some form of indexa-
available to cover the losses should their bank fail. tion, up from 11 percent in 2010. The percentage of
Accumulating funds to assure this confidence can be countries in the high institutional quality group that
highly costly, but it is necessary in low institutional had indexation was only 16 percent in 2016, up from ten
quality countries. Consistent with this notion, the percent in 2010. This observation also supports the
empirical evidence from the BRSS survey shows that idea that low institutional quality countries are trying
the size of accumulated funds with respect to total to keep their deposit insurance coverage credible by
insured deposits is negatively related to institutional automatically adjusting the coverage in response to
quality. Figure 3 shows the relationship between the higher inflation or per capita income.
insurance funding ratio (accumulated funds divided by Although adequate funding of insurance schemes
total insured deposits) and institutional quality. We see is important for deposit insurance to be credible, dur-
that low institutional quality countries tend to accumu- ing the GFC, many countries substantially expanded
late more funds ex ante, possibly to build credibility. In both the scope and the coverage of deposit insurance
particular, a one standard deviation increase in institu- in order to restore stability in their banking sectors.
tional quality (0.81 points increase in the index) is Setting clear and limited commitments ex ante is just
related to a 1.3 percent reduction in the deposit insur- as crucial as credibility for deposit insurance to work
effectively. Expanding cover-
Figure 4 age beyond what was prom-
ised to depositors during the
Use of Deposit Insurance Funds crisis had the effect of reinforc-
2016 2010 ing market expectations that
the government will step in to
bail out banks and depositors
65
should the need arise. These
Above median institutions
types of expansions reduce
21
market discipline and can lead
to greater risk-taking by banks.
Consistent with this notion, a
35 number of papers have shown
Below median institutions that more generous deposit
27 insurance coverage and scope
result in greater moral hazard
0 10 20 30 40 50 60 70 % (Honohan and Klingebiel 2000;
Note: The figure presents countries, in which the deposit insurance fund is used for purposes other than depositor Demirgüç-Kunt and Detragi-
protection.
ache 2002).
Source: Authors’ calculations from BRSS and WGI (2019). © ifo Institute
Moreover, limited ex ante
Figure 5 commitment by governments
Changes in Deposit Insurance Coverage and Scope also reduces the costs that
arise from providing insurance
Above median institutions during times of distress. As
Below median institutions bank runs often coincide with
%
80 73 deteriorating economic condi-
70 tions and declining asset val-
60 55 ues, ex post expansion of guar-
50 antees can be very costly for
43
taxpayers (Allen, Babus, and
40
Carletti 2009). Since fiscal
30
costs are limited, ex ante com-
18
20
mitment not to expand insur-
10 ance can improve the reliabil-
0 ity and credibility of deposit
Expansion of coverage Increase in amount insurance schemes. Limited
Note: The figure presents countries introducing changes to their deposit protection system as a result of the
2007-2009 global financial crisis.
commitment also ensures that
Source: Authors’ calculations from BRSS and WGI (2019). © ifo Institute deposit insurance schemes are
6 ifo DICE Report I/ 2019 Spring Volume 17FORUM
Table 1 harmonized across countries. This approach levels the
List of Countries (Median Institutional Quality playing field across different countries and helps to
Is between Bulgaria and South Africa) reduce regulatory arbitrage whereby investors move
funds to countries where they expect the local author-
Above median institutions Below median institutions
ities to increase coverage during times of stress.
Australia Angola Despite the benefits of limited commitment, dur-
Austria Argentina ing the GFC, there was a significant expansion of
Belgium Armenia deposit insurance in both scope and coverage. As of
Bhutan Bahrain 2016, around one-fourth of high institutional quality
Botswana Bangladesh countries and one-third of low institutional quality
Canada Belarus countries reported compensating deposits that were
Cayman Islands Belize not explicitly covered at the time of a bank failure.
Chile Bosnia and Herzegovina
Moreover, deposit insurance funds have also been used
for purposes other than covering specific depositor
Costa Rica Brazil
losses. Figure 4 shows the percentage of countries in
Croatia Bulgaria
each institutional quality group in which depositor
Cyprus Burundi
funds were used for other purposes, such as liquidity
Denmark Colombia
support, bank resolution, or recapitalization of weak
Estonia Dominican Republic
banks. In 2010, 27 percent of countries in the low-qual-
Finland El Salvador ity institutions group used deposit insurance funds for
France Fiji other purposes, compared to just 21 percent of coun-
Germany Ghana tries in the high-quality institutions group. However,
Hong Kong SAR, China Greece after the crisis, a higher percentage of countries in the
Hungary Guatemala high-quality institutions group used deposit insurance
Iceland Guyana funds for other purposes—65 percent compared to
Ireland Honduras
35 percent of countries in the low-quality institutions
Israel India
group.
Most of these changes came during the finan-
Italy Indonesia
cial crisis. Figure 5 shows the percentage of coun-
Jersey Jordan
tries in each institutional quality group that have
Korea, Rep. Kenya
made changes to their deposit insurance schemes in
Latvia Kyrgyz Republic
response to the GFC. Most countries, especially those
Liechtenstein Lebanon in the high-quality institutions group, significantly
Lithuania Lesotho increased both the limit and the type of accounts cov-
Luxembourg Malawi ered under deposit insurance. Specifically, 73 percent
Macao SAR, China Maldives of the countries in the high-quality institutions group
Malaysia Mexico increased the coverage amount. In the US, for exam-
Malta Moldova ple, the guaranteed limit (per depositor, per bank) was
Mauritius Morocco increased from USD 100,000 to USD 250,000 in 2008 to
Netherlands Mozambique
restore confidence in the banking system at the height
of the financial crisis. Of the countries in this group, 43
New Zealand Nicaragua
percent also increased the type of liabilities covered
Norway Nigeria
by deposit insurance. In Ireland, deposit insurance was
Oman Pakistan
expanded to cover all bank liabilities. There was also
Poland Panama
significant expansion in low institutional quality coun-
Portugal Peru tries: 18 percent expanded the scope, and 55 percent
Romania Philippines increased the amount covered by deposit insurance.
Seychelles Russian Federation Although it is difficult to quantify the long-term effects
Slovak Republic Sri Lanka of these expansions, they will nonetheless have an
Slovenia Suriname adverse impact on market discipline in the future.
South Africa Tajikistan In this article, we have shared some empirical
Spain Tanzania snippets from the latest BRSS survey. Overall, the
Switzerland Thailand
results in the survey reinforce the importance of the
larger institutional environment in how well deposit
Taiwan, China Trinidad and Tobago
insurance schemes are designed and function. It is
United Kingdom Uganda
important to emphasize that poorly designed schemes
United States Vanuatu
in lower-quality institutional environments can
Uruguay Zimbabwe
increase the likelihood of a banking crisis. Thus, it is
Source: WGI (2019). possible for explicit deposit insurance to do more
ifo DICE Report I/ 2019 Volume 17 7FORUM
harm than good for financial stability in countries
with such environments.
REFERENCES
Anginer, D. and A. Demirgüç-Kunt (2018), “Bank runs and moral hazard:
A review of deposit insurance”, The World Bank.
Angkinand, A. P. (2009), “Banking regulation and the output cost of
banking crises”, Journal of International Financial Markets, Institutions
and Money, 19(2), 240–257.
Angkinand, A. and C. Wihlborg (2010), “Deposit insurance coverage,
ownership, and banks’ risk-taking in emerging markets”, Journal of
International Money and Finance, 29(2), 252–274.
Bank Regulation and Supervision Survey (2019). World Bank. https://
www.worldbank.org/en/research/brief/BRSS.
Bonfim, D. and J. A. C. Santos (2017), “The importance of deposit insur-
ance credibility”, mimeo.
Calomiris, C. W. and A. Powell (2001), “Can emerging market bank regu-
lators establish credible discipline? The case of Argentina”, 1992–99.
In Prudential supervision: What works and what doesn’t (147–196). Uni-
versity of Chicago Press.
Cull, R., M. Sorge and L. W. Senbet (2004), “Deposit insurance and bank
intermediation in the long run”, BIS Working Paper No. 156.
Demirgüç-Kunt, A. and E. Detragiache (2002), “Does deposit insurance
increase banking system stability? An empirical investigation”, Journal
of Monetary Economics, 49(7), 1373–1406.
Demirgüç-Kunt, A. and E. J. Kane (2002), “Deposit insurance around the
globe: Where does it work?”, Journal of Economic Perspectives, 16(2),
175–195.
Dewenter, K. L., A. C. Hess and J. Brogaard (2018), “Institutions and
deposit insurance: Empirical evidence”, Journal of Financial Services
Research, 54(3), 269–292.
Diamond, D. W. and P.H. Dybvig (1983), “Bank runs, deposit insurance,
and liquidity”, Journal of Political Economy, 91(3), 401–419.
Honohan, P. and D. Klingebiel (2000), “Controlling the fiscal costs of
banking crises”, World Bank Policy Research Working Paper Series
No. 2441.
Hovakimian, A., E.J. Kane and L. Laeven (2003), “How country and safe-
ty-net characteristics affect bank risk-shifting”, Journal of Financial
Services Research, 23(3), 177–204.
World Governance Indicators (2019), World Bank. http://info.world-
bank.org/governance/wgi/#home.
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