DEPOSIT INSURANCE AND BANKING CRISES IN THE SHORT AND LONG RUN

There has been a rising global trend for countries, especially in the emerging economies, to institute explicit deposit insurance schemes in the last two decades. During this period, financial markets in the world have been frequently plagued by instabilities and banking crises, notably the Mexican crisis in 1995 and the Asian financial crisis in 1997, not to mention the recent meltdown of Argentina. Among the ninny arguments in favor of deposit insurance, protection of small depositors and prevention of systemic banking crises are the ones most often put forward by regulators to rationalize deposit insurance from a public-interest perspective. (1) Nonetheless, the public-interest argument based on protection of small depositors cannot adequately justify deposit insurance because there are alternatives such as short-term treasury securities (Benston and Kaufman 1988: 65), checkable money market mutual funds (Cowen and Krozner 1990), and government savings bonds (Chu 2000) that can achieve the same goals at lower cost. The justification of deposit insurance therefore rests to a large extent on its effectiveness in averting systemic banking crises and contagious bank runs due to asymmetric information (Diamond and Dybvig 1983). That public fear is widespread, even though several studies have clearly demonstrated that the contagion argument is exaggerated (Benston and Kaufman 1995; Calomiris and Mason 1997; Kaufman 1994, 2000), and that asymmetric information does not necessarily lead to bank runs because banks have incentives to signal their quality (Chu 1999). As Kaufman (2000) summarizes, the evidence for the United States strongly suggests that contagious bank runs are neither widespread nor long lasting, and there is no evidence that a bank run drives a solvent bank into insolvency. (2) Nonetheless, many countries have established deposit insurance during or after banking crises or financial instabilities, hoping to restore stability and prevent future crises. A well-known example is the Federal Deposit Insurance Corporation, which was set up after the United States experienced massive bank failures during the Great Depression. More recent examples include those East Asian countries, such as Malayasia and Indonesia, hit hard by the Asian financial crisis. Indeed, financial crises can be extremely costly. Although the cost of restructuring the banking industry varies from country to country, ranging from 4.3 percent to 45 percent of GDP (Dziobek and Pazarbasioglu 1997), its distribution appears to skew toward the high-cost end. (3) These high-cost figures tend to justify, at least on the surface, the existence of a financial safety net such as deposit insurance. However, are countries entirely immune from banking crises after instituting deposit insurance schemes? The answer is definitely no, as evidenced by the notorious U.S. saving-and-loans debacle in the 1980s (Kane 1989), not to mention similar incidents in other countries like Canada (Carr, Mathewson, and Quigley 1995). In evaluating feasibility of deposit insurance, therefore, a relevant question is, does deposit insurance reduce the likelihood of a banking crisis? If so, deposit insurance is justifiable because the expected benefits from avoiding substantial welfare or output losses due to a severe banking crisis are likely to outweigh the total cost of deposit insurance. Against that backdrop, this paper compares the banking stabilities of 174 countries during the 1980-2000 period to examine whether banking crises are less likely to occur in countries with deposit insurance than in those without. The empirical approach and findings of this study shed light on the relation between deposit insurance and banking crises over time. Some empirical studies have addressed the issue of whether deposit insurance undermines or promotes banking stability. These include individual country studies such as those by Keeley (1990), Grossman (1992), Cebula and Belton (1997) for the United States, and by Carr, Mathewson, and Quigley (1995) for Canada. …

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