The Importance of Deposit Insurance Credibility

Abstract

The success of deposit insurance arrangements at eliminating bank runs is likely closely tied to their credibility. We investigate this hypothesis building on two episodes which tested the insurance protection offered by the Portuguese arrangement in the midst of the country’s sovereign debt crisis. Our results show that Portuguese depositors responded to foreign banks’ decision to convert their subsidiaries into branches by relocating their deposits into the latter. We find a similar response following the announcement that insured depositors in Cyprus would lose part of their savings. On both instances responses are concentrated on household deposits. Given that foreign banks’ branches offer the insurance protection of these banks’ home countries, rather than that granted by their host country arrangement, our findings confirm that the credibility of the deposit insurance arrangement is critical for the protection it offers banks against the risk of depositor runs. These results show that sovereign-bank links can be detrimental to financial stability through a novel channel: the credibility of deposit insurance.