Deposit Insurance, Market Discipline, and Bank Risk

Abstract: Using evidence from Russia, we explore the effect of deposit insurance on bank behavior and performance. Drawing on cross-sectional, bank-level variation in the ratio of deposits held by insured households and uninsured firms, both before and after the introduction of explicit deposit insurance, we demonstrate that banks at which the decline in market discipline was relatively large were more likely to experience a greater subsequent increase in traditional measures of bank risk and a greater subsequent rate of failure. These results are robust to the inclusion of time-varying bank-specific controls, alterations to the time horizon for assessing bank risk, the exclusion of observations from after the global financial crisis and bank-level fixed effects. Moreover, they hold in a difference-in-difference setting in which state and foreign-owned banks, whose deposit insurance regime has not changed over our period of analysis, serve as a control.