New Research: How Deposit Insurance Increases Systemic Risk

New Research: How Deposit Insurance Increases Systemic Risk

A new paper from the National Bureau of Economic Research by Charles Calomiris and Sophia Chen shows how the increased adoption of deposit insurance (DI) over the past 40 years has increased systemic risk by incentivizing banks to take on riskier assets.

We construct a new measure of the changing generosity of deposit insurance for many countries, empirically model the international influences on the adoption and generosity of deposit insurance, and show that the expansion of deposit insurance generosity increased asset risk in banking systems. We consider three asset risk measures: higher loans-to-assets, a higher proportion of lending to households, and a higher proportion of mortgage lending. None of the observed increases in these indicators is offset by declines in banking system leverage. We show that increased asset risk explains at least part of the positive association between deposit insurance and the likelihood and severity of systemic banking crises.

The U.S. became one of the first countries to create deposit insurance during the Great Depression (despite President Roosevelt’s skepticism), and the result was reduced depositor monitoring.

But, in addition to reducing monitoring by depositors, Calomiris and Chen find that the relatively recent wave of DI creation has, on balance, increased systemic risk in the financial system by creating “moral hazard” within deposit-taking financial institutions.

This moral hazard manifests itself in two ways. First, the authors find that an increase in deposit insurance coverage increases a bank’s loan-to-asset ratio, the riskiness of banks’ portfolios, and the leverage of insured banks. While deposit insurance does reduce the risk of a bank run by increasing liquidity, “the moral-hazard and adverse-selection disadvantages of deposit insurance tend to outweigh its liquidity risk-reducing advantages.”

In other words, banks insured by the taxpayer make riskier investments that lead to a net loss in financial stability by increasing both the risk and severity of financial crises.

Second, and more relevant to the most recent financial crisis, the authors find that deposit insurance makes it easier for government to encourage greater mortgage lending, and that “[o]nce deposit insurance frees banks from constraints of market discipline, governments may be more able to use the regulation of the banking system as a means of targeting credit subsidies to household owners.”

Because mortgage lending, which has grown as a share of GDP, is particularly risky (home prices tend to follow broader economic growth or contraction), these findings demonstrate the pitfalls of deposit insurance. Not only does it encourage banks to make riskier loans, but it also enables government to encourage risky lending by covered banks.

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By |2018-09-06T12:04:33-07:00September 6th, 2018|Blog, Financial Regulation|