Two Essays on Deposit Insurance Coverage Levels

Deposit Insurance and Market Discipline: Limited coverage is a standard feature in deposit insurance schemes. It is used to limit moral hazard, and achieves this objective by reinforcing market discipline: depositors have more incentives to monitor banks’ risk-taking if they have skin in the game. In this paper, I study market discipline and coverage levels by analyzing the relationship of funding costs and deposit growth with banks’ leverage, non-performing loans, and profitability. I use a database of Colombian banks’ balance sheets and take advantage of a sudden, significant, and exogenous increase in the coverage level that occurred in 2017. I find evidence of market discipline throughout the period of analysis, and there is no indication that it was reduced by the change in the coverage level. The results vary, however, when I look at specific groups of banks separately. Market discipline is no longer present when analyzing only big banks and banks concentrated in insured deposits, where limited coverage has a less prevalent role. Finally, in banks that rely more heavily on uninsured deposits, there is evidence of market discipline, and the data show that it was reduced when coverage increased.

Coverage Levels in Deposit Insurance: to Increase or not to Increase: This paper studies the impact on welfare of changes in coverage levels within deposit insurance schemes. The paper builds on previous literature by adding the possibility of bailouts for too-bigto-fail banks and incorporating a time lag between deposit payout and recoveries. Banks are also allowed to adjust deposit rates, and I include the effect this has on welfare. I show how to link theoretical results in this expanded model to observable variables, and I apply it to Colombia’s 2017 increase in its coverage level. I estimate all the model’s parameters from data and calculate the impact on welfare of this increase in coverage. Benefits outweigh costs, although the net effect is modest in size and sensitive to some of the parameters. Key variables are size, the probability of default and the impact the change in the coverage level has on the amount of insured deposits. Bailouts have mixed effects but overall raise the costs of increasing coverage levels. So does including a time lag between payout and recoveries. Allowing banks to adjust deposit rates also leads to larger costs because of higher deposit rates.