Deposit insurance and the risk premium in bank deposit rates

By placing a ceiling on the amount of possible depositor loss, deposit insurance should result in a lower deposit risk premium. However, this effect may be modified if either the insurance promise has low credibility or the moral hazard incentives generated by deposit insurance result in a greater probability of bank default. Using financial and institutional panel data from thirteen countries, we find that the risk premium is over 40 basis points higher on average in uninsured countries than in countries that offer insurance up to some pre-specified maximum. However, the risk premium has a non-linear relationship with the level of maximum insurance coverage, suggesting that the market recognizes the moral hazard potential. Moreover, the effect of deposit insurance on the risk premium is weaker in countries with strong creditor rights, consistent with the view that investors view the latter as a substitute for explicit deposit insurance. (C) 2003 Elsevier Science B.V. All rights reserved.