Making Banks Pay - Extending Deposit Insurance Schemes

The global financial crisis in 2008/09 revealed the fragility of modern finance when governments in Europe and elsewhere needed to rescue banks with recapitalizations and guarantees. While these emergency programs have been scaled back, another form of intervention has remained: Deposit guarantee schemes were expanded during the crisis and have stayed at these higher levels. The aim of these schemes is to protect ordinary savers and keep them from lining up in front of banks to withdraw their money (an aim that has returned to the fore with the run on the British bank Northern Rock). Because deposit insurance schemes are most often funded by banks, they are – in principle – a mechanism to increase the resilience to crises by placing costs on those who create financial risks – on banks. The extent to which these banks have to pay for depositor protection and whether these schemes help to prevent future crises depend, however, on the scheme's funding rules and its provisions to curb moral hazard. In this paper, I argue that financial crises allow governments to implement or ratchet up deposit insurance schemes as they weaken banks’ opposition. While this extension effect applies to financial crises generally, the contributions by banks and the implementation of moral hazard provisions emerge from government-bank negotiations and hinge on the varying degree of banks’ bargaining power.