Before proceeding into more detailed discussion, it would be useful to make three points regarding the literature. The first point is that perhaps as a result of the US savings and loans crises, the literature on deposit insurance is primarily focused on the US and most authors who have contributed are US based. Second, analysing deposit insurance and the specific relationship this has with moral hazard and bank failures has a large and well-developed literature of its own. Third, the literature is large both in breadth (adjacent areas of enquiry) and in depth (detailed analysis of very specific issues); therefore a comprehensive review is beyond the ambitions of this chapter. Instead what is presented herein is a summary of the major aspects of the literature and key contributions.
Explicit deposit insurance has contributed to bank insolvencies in several countries, for example, Norway and Finland, and most notably the US S&L crises of the 1980s.5 It is now a fairly well-established premise that explicit deposit insurance can act as a double-edged sword. On the one hand, given that bank balance sheets typically have money uncertain assets and money certain liabilities, in the absence of deposit insurance, depositors may seek their funds and cause instability in the system. On the other hand, the presence of explicit deposit insurance may create incentives to excessive risk taking by bankers (moral hazard) which when realized (or even suspected) may lead to bank runs and instability in the system. Moral hazard in banking arises when banks are provided with incentives to take risks, can retain the returns, but at the same time can pass the (potential or realized) costs of the risks to depositors, regulators or the taxpayers. Banks secure in the safety net provided by the government feel free to take on higher levels of risk. Depositors who believe that their deposits are safe do not take as much care as they should in monitoring banks and as a result do not send appropriate market discipline signals, for example, by demanding higher interest rates or withdrawing their deposits. Another way of interpreting the behaviour of depositors in a high-risk banking environment with explicit deposit insurance is to suggest that as result of the high information asymmetries, depositors are incapable of monitoring managers and that managers are aware of this and free ride on depositors and the taxpayer.
The above view of explicit deposit insurance vividly illustrates the difficulties inherent in designing an optimal bank regulatory policy. Accordingly, the debate on optimal bank regulation and whether or not explicit deposit insurance has a role to play within such a framework has been quite extensive; see for example, Giammarino et al. (1993), Thakor
(1993) and Bhattacharya et al. (1998). Seen in one way, as Rajan (1992) points out, given the insider-outsider problem and information asymmetry, optimal bank regulation may only be attainable via an increase in bank self-regulation. Yet the difficulty of implementing such solutions lies in the creation of workable incentives that allows the equilibrium that arises from greater self-regulation to maximize the welfare function for banks, regulators and taxpayers.
Furthermore, it can be argued that as innovations in financial products and services continue to evolve, the level of information asymmetry which bank regulators face increases. This would be the case even if the regulator learnt from previous experiences and attempted to monitor developments. This makes the cost of pure public sector bank regulation prohibitive. It is for this reason that some, such as Mishkin (1996), suggest that some form of public sector optimal bank regulation can only take place if banks are provided with incentives to behave in ways that reduce information asymmetry for regulators. Seen in this light, it is not surprising that whether or not explicit deposit insurance is useful or harmful, is often discussed in the following context: first, the extent to which it creates inappropriate incentives, second, the appropriate pricing of bank risk-taking behaviour and third, how this deviates from optimal bank regulation.
Given the framework under which the discourse is usually held, the literature on explicit deposit insurance is usually embedded within the context of the search for an optimal bank regulation framework; it therefore focuses primarily on moral hazard and the efficacy or otherwise of incentives to avoid moral hazard. Diamond and Dybvig (1983) rigorously explain the way in which moral hazard emanates in the first instance. They suggest that in a production economy with stochastic liquidity shocks, banks primarily serve to provide optimal intertemporal insurance to consumers. Although this is a narrow definition of the intermediation role which banks play, it infers the problem of information asymmetry faced by depositors and regulators - which creates the opportunity for moral hazard to exist. However, von Thadden (1997) suggests that a fuller understanding of the moral hazard problem can be achieved if the definition of banks is extended beyond Diamond and Dybvig's narrow definition. Others have made contributions in this area.6 For example, the study of Karels (1997) accentuates the potential for moral hazard which the absence of depositor and market discipline creates. Under the present risk-based premium structure, asset risk has the potential to decline when the regulatory agency raises capital requirements.
Yet the ability and temptation to pass downside risk of financial operations is neither limited to the banking industry nor is it new. For example, Brewer et al. (1997) provide further evidence (from outside the banking industry) of the significance of increasing the potential liabilities of creditors, so that they, in turn, increase their monitoring efficiency and reduce moral hazard.7 Furthermore, the prominence which moral hazard has received as an explanation for the savings and loan problem might suggest that moral hazard is a recent phenomenon. But it is not. Bodenhorn (1996) explains that the first experiment with deposit insurance in the US was the New York Safety Fund. The New York Safety Fund was founded in 1829 and ended nearly as disastrously as the S&L crises of the 1980s for the same reasons. Hooks and Robinson (1996) provide evidence to support the view that moral hazard existed in US Texas state chartered banks in the 1920s. A state-run deposit insurance system was in place at the time and membership was mandatory for all state chartered banks in Texas. Consistent with the role of moral hazard in increasing ex ante risk, the individual bank-level data reveal that declines in capitalization were positively correlated with increases in loan concentrations at insured banks. In addition, Gunther and Robinson (1990) explain that after a 60-year period of relative stability, this problem arose again in Texas. They show that the ratio of a bank's capital adequacy is an important factor in determining how likely it is to succumb to deposit insurance moral hazard incentives and take on higher risks. They also show that deregulation and increased competition probably interacted with moral hazard in the recent period of widespread bank insolvencies and failures. This leads to the suggestion that the recent episode of deposit insurance moral hazard may lie behind the transition from the well-balanced bank portfolio characteristics of stable banking periods to the higher-risk portfolios which are a usual characteristic of banks when their capital levels drop below adequate regulatory standards.
To enable further insight on this issue, the extent to which deregulation can be blamed for the large number of failures caused by the moral hazard of deposit insurance has also been tested. But deregulation of the banking industry should not be confused with bad bank regulation and super-vision.8 Fraser and Zardkoohi (1996) test the deregulation hypothesis -which argues that banks and savings and loans associations take on more risk in a deregulated environment. They show that savings and loans take on more risk in a deregulated environment which has inappropriate bank regulation.
This is in keeping with the findings of Grossman (1992), who explains that inadequate implementation of bank regulation and supervision is mistakenly construed as deposit insurance moral hazard. In an analysis of the risk-taking behaviour of insured and uninsured institutions operating under strict and less strict regulatory regimes, he shows that insured institutions which operate under less strict regulatory regimes are more likely to undertake more risky lending activities than those which are more tightly regulated. Although, prima facie, this fits in with moral hazard, the results also suggest that deposit insurance was not the sole culprit of the higher insolvencies and failures that took place among the institutions from the less strict cohort. Rather, the problem was caused by a combination of deposit insurance and inadequate sequencing of deregulation. The results suggest that since deposit insurance still requires careful reform, further bank deregulation should be viewed and undertaken with caution. And most importantly, if the system of explicit deposit insurance is not reformed to remove all the moral hazard loopholes, then the level and quality of on-site and off-site bank regulation and supervision has to improve.
Incentives, Deposit Insurance and Bank Behaviour
As noted earlier, the evidence in the literature also suggests that careful assessment and development of appropriate incentives lie at the heart of the attainment of effective explicit deposit insurance. Incentives can yield unexpected positive as well as unexpected negative or adverse outcomes. Wheelock and Khumbakar (1995) analyse the incentive effects of deposit insurance by examining the insurance system of the US state of Kansas over the 1909-29 period in which it operated. They show that while the Kansas system had a number of unique features, such as voluntary membership, which were incorporated to limit risk taking, it also suffered from both adverse selection and moral hazard. In addition, after controlling for the insurance selection effect, the Kansas DIS encouraged insured banks to hold less capital relative to uninsured banks. The premium structure did not provide the appropriate incentives to insured banks to hold more capital -on the contrary, it encouraged them to choose greater leverage than their insured competitors. This is not surprising since the nature and selection of members into a DIS is an important decision which can greatly influence the success or failure of a scheme.
Along the same lines, Mazumdar (1996) analyses the joint impact which the US Federal Reserve Bank System's discount window credit and reserve requirements and the FDIC's deposit insurance have on bank optimal capital structure and asset risk choice. It is found that the presence of the discount window does not always prompt bank risk taking and leverage but it does partially offset such incentives under certain indirect subsidies that may encourage deposit funding. Therefore Mazumdar suggests that regulatory reforms, for example the enactment of the FDICIA of 1991, may not sufficiently resolve banking firms incentives for moral hazard behaviour.
One solution to the difficult objective of providing an appropriate incentive-based deposit insurance framework is provided by Kupic and O'Brien (1998). Their study illustrates that where commonly used modelling stylizations on bank investment and finance choices are relaxed there are difficulties in designing optimal bank regulatory policy. To resolve this, they show that when banks can issue equity at the risk-adjusted risk-free rate, collateralization of deposits with a risk-free asset costlessly resolves some of the factors that encourage moral hazard, such as inadequate pricing of deposit insurance.
Along the same lines, Nagarajan and Sealey (1998) have developed a model of incentive compatible bank regulation. They illustrate that with regulatory instruments which involve ex post pricing contingent on the bank's performance relative to the market, conceptually implementable mechanisms can solve each type of deposit insurance incentive problem separately and achieve the first-best outcome. A major aspect of this contribution is that the mechanisms suggested do not involve a subsidy to the bank. When the regulator simultaneously faces moral hazard and adverse selection, conditions are identified under which the same mechanism can achieve the first-best solution.
Yet Stroup (1997), among others, explains that bank debt as a source of debt finance is declining as firms tap the capital (bond) market for debt finance. The corollary is that a substantial transfer of deposits from banks to other parts of the financial system is taking place. The catalyst for these two trends has been the increase in non-bank competition, the reduction in banking industry profits and the perception of increased risk as a result of the high bank failure of the 1980s in the US and 1990s elsewhere. Since one of the stated objectives of deposit insurance is to ensure financial stability, given the trends just stated, the value of explicit deposit insurance in attaining this objective becomes debatable. As assets migrate from insured institutions, deposit insurance exerts less of a stabilizing influence on the overall financial system. In effect an insurance programme which applies to a shrinking segment of the modern financial services market cannot play the role of ensuring the stability of the entire system.
So Gorton and Rosen (1995) explore the incentive role which fixed-rate deposit insurance has played in encouraging the decline of bank intermediation. They test an alternative hypothesis based on corporate control considerations and find that managerial entrenchment provides a better explanation for, and played a more significant role than explicit deposit insurance in encouraging, moral hazard in the recent behaviour of banks.
Gorton and Rosen's finding that moral hazard is not solely a consequence of explicit deposit insurance design is supported by the findings of Crawford et al. (1995), who test the agency theory deregulation hypothesis which posits that bank chief executive officer compensation becomes more sensitive as banks and the action which their management can take become less regulated. Their findings indicate a significant increase in pay-performance sensitivities in the United States over the pre-deregulation period (1976-81) and the deregulation period (1982-88). The increases in pay sensitivities are observed for salary and bonus, stock options and common stock holdings. Furthermore, the increases in the pay-performance relation associated with high capitalization ratio banks were observed to be consistent with providing incentives for wealth creation. In addition, even larger increases in pay-performance sensitivity for lower capitalization ratio banks suggest a deposit insurance moral hazard problem.
In addition to the above, while many of the moral hazard problems of deposit insurance have been related to on-balance sheet risk-taking behaviour, it is important to note that developments in off-balance sheet and derivative finance have also increased incentives and the scope for moral hazard in deposit insurance. Peek and Rosengreen (1997) explain that because of the moral hazard associated with deposit insurance, troubled banks with relatively small capital adequacy cushions with which to absorb losses have an incentive to take speculative positions. If this is the case, then the prevalence of problem banks among those actively engaged in derivatives markets should be of concern to bank supervisors. The derivatives activity at troubled banks should raise the same concerns expressed about banks' on-balance sheet positions; namely that given the presence of explicit deposit insurance, banks may not be fully exploiting hedging opportunities or may be placing their remaining capital at risk. However, Peek and Rosengreen suggest that bank supervisors do not take into account (favourably or unfavourably) the derivatives activities of troubled banks in their decisions to downgrade bank ratings or impose regulatory actions.9
Furthermore, despite all the incentives to avoid risk taking and moral hazard explained above, whenever bank insolvencies occur there is still the perceived need for deposit insurance. Thus, as Flood (1996) explains, the history of the demand for introduction of explicit DIS is correlated with the experience of bank insolvencies and although some, for example Calomiris (1990), believe that the financial regulatory authorities can still play the LOLR role effectively via the constructive ambiguity of an implicit deposit insurance, others, for example Garcia (1997), have countered (with the view based on a narrow premise of Diamond and Dybvig) that the presence of an explicit DIS supports the stability of the financial system by providing the ready bank liquidity with which to assure depositors that they will have immediate access to their funds even if their banks fail and that this will reduce the likelihood of a run on banks and prevent a crisis. So, despite the risks of moral hazard, the introduction of explicit deposit insurance is increasing internationally because it is felt that the benefit of deposit insurance outweighs its costs.
Discouraging bank runs can in itself prevent a sense of panic from spreading in the financial system. Panic and threats to systemic stability can choke off liquidity and cause healthy as well as insolvent banks to fail. Careful structuring of the incentives of the managers of the DIS so that they maintain and protect members' funds, augmented by other agencies responsible for bank monitoring and supervision, is essential for effective deposit insurance to provide market discipline to banks.
In sum, a DIS will provide the financial authorities with standby funding and guidance regarding the decision as to which banks to inject liquidity into and which to let fail. Insolvent banks may fail because they are insolvent - this is a market process. However, sometimes banks are illiquid, but not insolvent. By preventing the failure of banks experiencing a temporary liquidity crisis, an explicit DIS can contribute to financial stability. Thus an explicit DIS with the right balance in design, administrative and managerial incentives, in close collaboration with other agencies, will be more able to make this assessment transparently and ensure stability in the financial system. Giles (1996) sums up this issue well by suggesting that the answer to addressing the difficult question of attaining the correct balance between efficiency and financial stability is to tighten regulation dramatically while retaining comprehensive explicit deposit insurance.
Was this article helpful?
How to profit from the global crisis and make big bucks big time! The current global financial crisis has its roots embedded in the collapse of the subprime markets in the United States. As at October 2007 there was an estimated loss on the subprime market of approximately 250 billion. If you want to come out on top, you have come to the right place.