·  How does deposit insurance lessen depositor discipline?

Evidence on market discipline as reflected in bank interest cost comes primarily

from U.S. experience. Flannery (1998) surveys research on how the interest cost of

uninsured bank deposits and other debt instruments in the U.S. responds to observable

measures of default risk. In the U.S., balances in excess of $100,000 are not insured.

Typically, researchers find that interest rates paid on these partially insured instruments

(certificates of deposits, CDs) increase significantly with bank riskiness. Linking

movements in CD rates to bank-specific news embedded in movements in stock prices,

Ellis and Flannery (1992) show that bank CD rates respond generally to market

perceptions of bank-specific risks.

Cook and Spellman (1994) find that, even on fully insured deposits, risk

premiums at U.S. savings and loan associations (S&Ls) responded to individual-

institution risk factors in 1987. This sensitivity to risk emerged because the deep

economic insolvency of their federal guarantor was becoming clear at that time. These

premiums served simultaneously to rein in gambling by aggressive S&Ls and their

insolvent insurer. This evidence indicates that inadequacies in supervision and insurer net

worth can reduce the credibility of an insurer's guarantees.

Moving beyond depositor reactions, Flannery and Sorescu (1996) study market

yield spreads between uninsured bank debentures and callable treasury bonds. These

spreads showed significant sensitivity to bank risk during the years 1989-1991 when the

mess was being cleaned up. This was also a time when doubts were emerging about

whether the FDIC could or would fully rescue creditors of insolvent bank holding

companies. The importance of variation in the credibility of implicit and explicit

guarantees is supported in a negative way by the behavior of spreads on bank derivatives

in the less stressful era of 1983-1984. Analyzing data from that era, Avery, Belton and

Goldberg (1988) and Gorton and Santomero (1990) failed to uncover any risk sensitivity.

Apparently, interest costs on insured deposits and uninsured instruments discipline

depository institutions ever more strongly when doubts arise about the insurer's ability to

cover its guarantees. Such doubts are endemic to developing countries and can accelerate

quickly.

Evidence on whether the deposit growth of banks is retarded by default risk

premiums is available from a wide spectrum of countries and time periods. Gorton and

Pennacchi (1990) explain why we should expect deposit growth to slow at a troubled

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