Discuss the role of market discipline in the regulatory measures that can be implemented in deposit insurance systems.   

Deposit insurance is one of the most controversial issues in economics. In theory,

deposit insurance can have either stabilizing or destabilizing effects on the banking

system. On the positive side, it can reduce the likelihood of liquidity crises and bank runs because it provides assurance to depositors that their assets are safe and secure. On the negative side, deposit insurance can distort incentives of both banks and depositors. In particular, insured depositors lose the incentive to select and monitor the banks into

which they put their deposits because their deposits are safe no matter how risky the bank

is. Consequently, unmonitored banks have ample opportunity and the incentives to

increase leverage and take excessive risk, which in turn destabilizes the banking sector in

the long run. Many researchers put these two opposing views to empirical tests in which they examine the relationship between deposit insurance structures and banking sector

stability. These studies present two important findings. First, the adoption of deposit

insurance increases the likelihood of banking instability. Moreover, more recent study by

Demirguc-Kunt and Detragiache (2002) presents strong evidence that badly designed

deposit insurance system magnifies these destabilizing effects. In particular, coverage

limits play an extremely important role in keeping the probability of banking crisis low.

The theoretical explanation for the importance of coverage limit is straightforward. With

a sufficiently low coverage limit, regulators can ensure that some depositors, especially

sophisticated large uninsured depositors, will have an incentive to monitor and punish

risky banks by charging higher risk premium and withdrawing deposits.

In high- transparency environments, depositors can discipline banks that engage in

excessive risk-taking by demanding higher deposit interest rates or by withdrawing their

deposits. However, to the extent that deposit insurance reduces the stake that depositors

have in monitoring and policing bank capital and loss exposures, it shifts responsibility

for controlling bank risk-taking to the regulatory system. Wherever deposit- insurance

managers displace more discipline than they exert, bank performance is undermined. To

understand this, I prefer to analyze these two questions:

·  How do depositors exert market discipline?

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