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Excessive Deposit Insurance Prompts Banks to Take More Risks

While helping build consumer trust in credit institutions, deposit insurance can prompt bankers to engage in risky and opportunistic behaviour; larger banks tend to be more cautious and do a better job managing troubled assets, according to Natalia Gorelaya, Associate Professor at the HSE Faculty of Economic Sciences’ Department of Finance.

Since 2004, Russa has had a Deposit Insurance System (DIS) covering more than 80% of the country's credit institutions. In the decade since it was established, compensation amounts have changed four times and increased 14-fold in total, from 100,000 to 1,400,000 rubles. According to experts, the availability of guarantees for depositors has greatly contributed to public confidence in the banking system – even the fairly frequent recent withdrawals of bank licenses have not caused any bank runs in Russia.

However, the country’s deposit insurance system can have a dual effect on the economy. While enhancing the financial sector's stability and public trust in banks, it can cause bankers to become complacent and over-confident, engaging in high-risk lending and investment and thus increasing their bank's total risks.

Associate Professor Gorelaya of the HSE Faculty of Economic Sciences’ Department of Finance conducted an empirical study to find out how the deposit insurance system affects market discipline and risk appetites for banks.

She performed her calculations on a large sample of Russian credit institutions' data collected since the introduction of deposit insurance (4,588 quarterly observations on 148 Russian banks participating in DIS between the first quarter of 2007 and the third quarter of 2014). Of the total sample, two subgroups were selected: large, mostly state-owned, banks and small credit institutions, and then the correlations between credit risk, liquidity risk, default risk and the characteristics of deposit insurance provisions were analyzed for each subgroup. Gorelaya presented her findings in the paper 'The Deposit insurance System and Its Effect on Risk-taking by Russian Banks'.

The Cost of Competition

According to Gorelaya, deposit insurance, in and of itself, does not increase banking risks. However, she found a relationship between the amount of insurance coverage and the level of risk exposure. This relationship is not linear, but quadratic: at first, Russian banks' risk appetites were decreasing with the increase in deposit insurance amounts, but when, in 2006, the insurance coverage reached a certain point (261,000 rubles, which is almost 5.5 times less than the 1,400,000 rubles established in December 2014), banks' risk-taking began to grow once again.

Gorelaya notes that "alongside positive effects, such as larger balances in deposit acounts, increased amounts of insurance coverage can also lead banks to take more risks." Knowing that most depositors expect to recover their funds no matter what and thus tend to ignore their bank's risktaking, certain credit institutions have engaged in risky policies trying to beat competition by offering better deals to their customers.

While deposit insurance coverage in Russia is fairly moderate by world standards – compared, e.g. to the U.S. where it is ten times higher at USD 250,000 – still, relative to the average size of bank deposits in Russia (29,000 rubles in 2014), its amount can even be described as excessive.

Large Banks Better at Calculating Risks

Gorelaya has also found that major Russian banks participating in DIS tend to be more cautious than smaller lenders: compared to small and medium-sized banks, they usually have a lower proportion of NPLs (non-performing loans) in their portfolios and thus can allocate a smaller part of their revenues to loan loss reserves.

In addition, large banks tend to do a better job managing troubled assets by reducing their size to acceptable levels, even when faced with large amounts of bad debt.

According to Gorelaya, a bank's capital to total assets ratio does not have an effect on its credit risk (defined as the NPL to total assets) and liquidity risk (expressed as liquid assets to liabilities ratio).

 

November 02, 2015