International Evidence on the Value of Deposit Insurance

Transcription

1 International Evidence on the Value of Deposit Insurance Luc Laeven 1 August 2001 Abstract: The goal of this paper is to improve our understanding of the costs and benefits of explicit deposit insurance. To this end we compare the opportunity-cost value of deposit insurance services for a large sample of banks drawn from countries with or without explicit deposit insurance. After correcting for certain bank-specific and countryspecific factors, we find that the existence of explicit deposit insurance raises the opportunity-cost value of deposit insurance, but that the presence of a sound legal system with proper enforcement of rules reduces the adverse effects of explicit deposit insurance on the opportunity-cost value of deposit insurance services. Our findings suggest that moral hazard and other incentive problems created by existing governmental deposit insurance schemes differ in magnitude between different types of banks and among different countries, and that explicit deposit insurance should not be introduced in countries with weak institutional environments. JEL Classification: G13, G21 Keywords: Deposit Insurance, Safety Net, Option Pricing 1 The World Bank, Llaeven@worldbank.org, Tel The author would like to thank Asli Demirgüç-Kunt and Ed Kane (the Editors), Thorsten Beck, Jerry Caprio, Stijn Claessens, Simeon Djankov, Patrick Honohan, Giovanni Majnoni, George Pennacchi, Sweder van Wijnbergen, and seminar participants at the World Bank Financial Economics Seminar for valuable comments, and Ying Lin for research assistance. The views expressed in this paper are those of the author and should not be interpreted to reflect those of the World Bank or its affiliated institutions.

2 Introduction Recently, many countries have implemented deposit insurance schemes and many more countries are planning to implement deposit insurance. The design of this part of the financial safety net differs across countries, especially in account coverage. Countries that introduce explicit deposit insurance make many decisions: which classes of deposits to insure and up to what amount, which banks participate, who should manage and own the deposit insurance fund, and at what levels explicit and implicit premiums should be set. When countries elect not to introduce explicit deposit insurance, insurance is implicit. In either case, the benefits banks gain depend on how effective the government is at managing bank risk-shifting. Explicit deposit insurance schemes appeal increasingly to policymakers. First, an explicit scheme supposedly sets the rules of the game regarding coverage, participants, and funding. Second, an explicit scheme is appealing to politicians because it protects small depositors without immediate impacting the government budget. One should, however, not ignore the potential cost of explicit deposit insurance. Because explicit deposit insurance may reduce the incentives for depositors to exert market discipline on banks, it can encourage banks to take excessive risks. This form of moral hazard has received a lot of attention in the literature (see, for example, Bhattacharya and Thakor (1993)). Because financial safety nets can be designed in many ways, it is useful to find out which system works best in which environments. In this paper, we investigate how country-specific and bank-specific features contribute to the opportunity-cost value of deposit insurance services, with a special focus on the comparison of the opportunity-cost value of deposit insurance services in countries with explicit deposit insurance and countries without explicit deposit insurance. To this end, we use a large sample of banks in fourteen different countries. We choose this sample such that both country and bank characteristics vary widely. We measure the opportunity-cost value of deposit insurance services of each bank by applying a well-known technique that models deposit insurance as a put option on the bank s assets. Henceforth, we use the terms opportunity-cost value of deposit insurance services and value of deposit insurance interchangeably. 2

3 In countries with explicit deposit insurance, deposit insurance is underpriced (overpriced) if the deposit insurer actually charges less (more) for its services than the estimated opportunity-cost value of these services. Underpricing of deposit insurance services is a sign that banks extract deposit-insurance subsidies. Sample countries with explicit deposit insurance underpriced insurance services on average during the sample period This implies that governments subsidized banks. The subsidy, however, varies across different types of banks. We find that the opportunity-cost value of deposit insurance services is higher in countries with explicit deposit insurance. The detrimental impact of explicit deposit insurance is largely offset in countries with high-quality and well-enforced legal systems. We also find that the value of deposit insurance has been higher for banks with concentrated ownership. Section 1 reviews the deposit insurance literature. Section 2 presents the methodology we apply to calculate the opportunity-cost value of deposit insurance services. Section 3 describes the data we use to estimate the opportunity-cost value of deposit insurance services. Section 4 presents our empirical findings. Section 5 concludes. 1. Literature Many countries adopt explicit deposit insurance to provide liquidity to banks facing bank runs and to prevent bank runs from happening. In most countries that have explicit deposit insurance, deposits are insured up to a formal limit. Limits render deposit insurance partial. In a few countries, such as Turkey, deposits are insured in full. This is complete deposit insurance. The advantage of complete deposit insurance is that the threat of bank runs is eliminated as long as the guarantees remain credible. On the other hand, complete deposit insurance destroys potentially beneficial information production and monitoring by depositors. The provision of deposit insurance also generates incentives for banks to take on risk. This type of moral hazard behavior is described at length in the deposit insurance literature. Merton (1977, 1978) first modeled the value of deposit insurance. Bhattacharya and Thakor (1993) model the incentives by which deposit insurance invites insured banks to seek excessive portfolio risk and keep lower 3

4 liquid reserves relative to the social optimum. An overview of the economics of deposit insurance is provided by Bhattacharya, Boot, and Thakor (1998). The effectiveness of deposit insurance has been shown to be country-specific. Demirgüç-Kunt and Huizinga (1999) offer empirical evidence that explicit deposit insurance introduces a trade-off between the benefits of increased depositor safety and the costs of reduced creditor discipline. Demirgüç-Kunt and Detragiache (1999) find cross-country evidence that explicit deposit insurance increases the probability of banking crises in countries with weak institutional environments. Cull et al. (2000) argue that the introduction of an explicit deposit insurance scheme should be accompanied by a sound regulatory scheme to deter instability and encourage financial development. Kane (2000) argues that the design of a country s financial safety net should take countryspecific factors into account, in particular differences in informational environments and the enforceability of private contracts. Demirgüç-Kunt and Kane (2001) conclude that explicit deposit insurance should not be adopted in countries with a weak institutional environment. In a seminal paper, Merton (1977) showed that deposit insurance can be modeled as a put option on the bank s assets. Marcus and Shaked (1984) use Merton s (1977) theoretical model to estimate the fair value of deposit insurance. By comparing these implicit premiums with the official insurance premiums for US banks they test empirically whether deposit insurance is over- or underpriced. For several reasons, the option-pricing model of deposit insurance gives downward biased estimates of the benefits bank stockholders derive from the safety net (Kane (1995)). First, the basic model in Merton (1977) ignores the possibility of regulatory forbearance. Ronn and Verma (1997) incorporate capital forbearance by the bank regulators by permitting asset values to deteriorate to a given percentage of debt value before the option kicks in. Hovakimian and Kane (2000) suggest assigning forbearance benefits only to economically insolvent banks. Second, by imposing prompt option settlement, a limited-term option contract understates stockholder benefits from deposit insurance. Pennacchi (1987) allows for unlimited term contracts and shows that the assumption of a limited-term contract can underestimate the value of deposit insurance. Finally, Kane (1995) argues that option-pricing models suffer from treating risk as exogenous and from modeling deposit insurance as a bilateral contract, thereby ignoring 4

5 the agency conflicts that arise from the difficulty of enforcing capitalization requirements in a multilateral nexus of contracts. Although research on the value of deposit insurance employs the option approach almost exclusively, the following authors extend the standard single-period model of deposit insurance to a multiperiod setting and incorporate a variety of features describing bank and regulator behavior, such as endogenous capital adjustments and regulatory forbearance: Pennacchi (1987a, 1987b), Allen and Saunders (1993), Cooperstein et al. (1995), Saunders and Wilson (1995), and Hovakimian and Kane (2000). Many of the empirical studies generated by Merton s model focus on the issue of over- or underpricing of deposit insurance. Duan and Yu (1994) use Duan s (1994, 2000) maximum likelihood method to assess fair deposit insurance premiums for ten listed depository institutions in Taiwan for the period 1985 to Their findings indicate that these institutions were heavily subsidized by the Taiwan deposit insurance fund of Taiwan during this period. Fries, Mason and Perraudin (1993) employ Ronn and Verma s (1986) method on sixteen Japanese banks for the period 1975 to They find that Japanese institutions were heavily subsidized by the deposit insurer. Hovakimian and Kane (2000) find that US banks shifted risk onto the safety net during the period 1985 to 1994, despite regulatory efforts to use capital requirements to control risk-shifting by US banks. Laeven (2001) interprets the estimate of the opportunity-cost value of deposit insurance services as a proxy for bank risk and shows that this proxy has predictive power in forecasting bank distress. He also finds that this measure of bank risk is higher for banks with concentrated ownership and high credit growth, and for small banks. 2. Methodology This section describes how we calculate the implicit value of deposit insurance services. We employ Ronn and Verma (1986) adaptation of Merton s (1977) theoretical model. Merton (1977) shows that the payoff on a perfectly credible third-party guarantee to a firm's bondholders is identical to that of a put option. The promised payment corresponds to the exercise price, and the value of the firm s assets corresponds to the underlying asset. In applying this model to a bank, corporate debt corresponds to deposits. Because most deposits are due on demand, the maturity of deposit debt is very 5

6 short. Customarily, the maturity of the option is conceived as the time until the next audit of the bank s assets. Two more assumptions are conventionally made. First, it is assumed that deposits equal total bank debt and that principal and interest are both insured. Second, the bank s asset value is assumed to exhibit geometric Brownian motion. This allows us to use the Black and Scholes (1973) option-pricing model to value the deposit insurance per US dollar of deposits. To apply the model, values have to be assigned to two unobservable variables: the bank s asset value and a volatility parameter. Ronn and Verma (1986) generate proxy values for these unknowns from two identifying restrictions. The first restriction comes from modeling the directly observable equity value of the bank as a call option on the bank s assets with a strike price equal to the value of bank debt. The relationship between the equity and asset volatility implied by the call valuation becomes the second restriction. Data on total debt, bank equity, and equity volatility allow the two restrictions to be solved simultaneously for the value of the bank s assets and the volatility of asset returns. From these two values, the value of deposit insurance per dollar of deposits can be calculated. We use the US dollar to normalize the values on a single currency unit. The Ronn and Verma (1986) method uses the sample standard deviation of daily stock returns as an estimator for instantaneous equity volatility. Duan (1994) points out that this is not an efficient estimator for instantaneous equity volatility. We acknowledge this shortcoming of the Ronn and Verma (1986) method and rely on the use of highfrequency data to improve the efficiency of the estimator. The method assumes that all debt is deposits and that all deposits are fully insured. This is an oversimplification. We also assume that the next audit of the bank will take place in one year, and that the debt matures at the audit date. We thus model deposit insurance as a limited-term contract. Since it is likely that the government will give the bank some forbearance after it finds out that the bank is undercapitalized modeling deposit insurance as a one-year contract is restrictive. It is clear that the value of insurance is higher if the audit indicates that a bank is undercapitalized and the government gives the bank forbearance instead of forcing it to immediately increase its capital ratio (Hovakimian and Kane (2000)). Since the level of regulatory control is unknown ex ante, we model deposit insurance as a limited-term contract, acknowledging 6

7 that the value of deposit insurance services might be underestimated. As long as any underestimation is similar across banks, our method would be valid for comparative purposes. However, the level of forbearance is likely to vary across countries. It is likely that regulatory control is weaker in countries with weak banks, so that we would underestimate the value of deposit insurance to the most risky banks. The contrasts we find using a limited-term contract would probably be stronger if we had modeled deposit insurance as a multiperiod contract. 3. Data We choose our sample of banks such that both country and bank characteristics vary widely. We do this to isolate the relationship between various country-specific and bank-specific factors and the value of deposit insurance. This dictates that we include banks from both developed and developing countries. To keep the dataset manageable, we limit the number of developed countries to seven: France, Germany, Hong Kong, Japan, Singapore, UK and US. Furthermore, we restrict our sample to banks that are listed on a stock exchange, since we need market valuations to use the put option approach to value deposit insurance. We estimate annual equity volatility from daily equity returns expressed in US dollars, and follow Fama s (1965) suggestion to delete days when the relevant stock exchange is closed. We also delete observations that occur on a day when it is announced that the bank will be restructured, merged or closed. Such announcements tend to generate large jumps in share prices, that distort the estimated volatility of equity returns. We limit the large number of listed banks in Japan and the US to the long-term credit, city and trust banks in the case of Japan and the multinational and superregional banks in the case of the US. In addition to the developed markets cited, the final sample includes banks from seven developing countries: Argentina, Chile, Indonesia, South Korea, Malaysia, Taiwan and Thailand. Across the fourteen countries, we have collected data on 144 listed banks during the period The banks in our sample include most of the major listed banks in the country. We are forced to exclude many banks from developing countries due to data limitations, mostly because of a lack of data on the ownership structure of these banks. 7

8 Data on daily stock market capitalization and annualized dividend yields come from Datastream. Total bank debt at yearend, net loans at yearend and ownership data are taken from BankScope. To minimize missing observations we also draw on Bloomberg. As threshold for a majority shareholding, we use a stake of 50% in the total number of shares. All financial data are converted from local currency to US dollars. Our final panel dataset has 950 usable observations for 144 banks and eight years. Mostly because of delistings during the sample period, 202 observations are missing. In addition, we collect data on a number of country-specific variables. First, we take figures on GDP per capita from the International Monetary Fund (IMF). Second, we use the Law and Order index of the International Country Risk Guide (ICRG), published by Political Risk Service. The Law and Order index serves as a proxy for the quality and enforcement of the legal system of a country. The Law and Order index ranges from 0 to 6, with a higher figure indicating a better quality and enforcement of the legal system. Third, data on the features of the deposit insurance scheme of individual countries come from Demirgüç-Kunt and Huizinga (1999), Garcia (2000) and Demirgüç-Kunt and Sobaci (2000). Four features of the deposit insurance schemes of the 14 countries are presented in Table 1: whether insurance is implicit or explicit, when an explicit system was established, whether participation in the explicit deposit insurance system is compulsory or voluntary, and the size of the explicit insurance premiums. Participation in the explicit deposit insurance scheme of all sampled countries is involuntary, except in Taiwan, where there are plans to make participation compulsory. The aforementioned data have been used in Laeven (2001), and the reader may find further details in this paper. [Insert Table 1 here] 4. Empirical Results We frame deposit insurance guarantees as a one-year put option on the value of bank assets for the 144 sample banks for each year in the sample period and use the Ronn and Verma (1986) method to value these services. Mean values for each country are presented in the second column of Table 2. The last two columns of Table 2 8

9 report the standard deviations of the estimates of the opportunity-cost value of deposit insurance services and the number of observations. The value of deposit insurance is highly country-specific. Over the sample period, the average opportunity-cost value of deposit insurance services ranges from low values of 0.02 basis points per US dollar of deposits for Chilean banks and 0.18 basis points per US dollar of deposits for German banks to highs of 136 basis points per US dollar of deposits for Thai banks and 154 basis points per US dollar of deposits for Indonesian banks. The low estimate for Chile may trace to having to limit ourselves to a sample of two Chilean banks. The low estimate for Germany appears to reflect the benefits of private ownership on the German deposit insurance fund. Beck (in this issue) describes the German deposit insurance scheme and argues that ownership of the deposit insurance fund by the German banks enhances private monitoring and reduced risk-shifting. The high estimates for Indonesia and Thailand are consistent the financial crises experienced by these two countries. [Insert Table 2 here] In addition to moral hazard, explicit deposit insurance schemes can lead to fiscal weakness if premiums are underpriced. We therefore investigate whether the countries in our sample with explicit schemes underpriced deposit insurance by setting premiums too low. Official deposit insurance premiums in our sample range from 0.0% to 0.72% of insured deposits. For countries with explicit deposit insurance schemes, the official premiums can be found in the second column of Table 2. In two distressed countries with explicit deposit insurance schemes -- Japan and Korea -- the actual premiums prove substantially lower than the average value of deposit insurance during the period The apparent underpricing of deposit insurance services in these two countries is, however, not statistically different from zero at conventional significance levels. For countries in our sample with explicit deposit insurance schemes, this implies that official premiums were adequate on average, although some individual banks in our sample might well have been charged a higher premium to reflect their risks. The figures in Table 2 also suggest that the opportunity-cost values of deposit insurance is lower on average for countries with explicit deposit insurance. The 9

10 opportunity-cost value of these services is 79.9 basis points per US dollar of deposits on average for countries without an explicit deposit insurance scheme (panel B of Table 2) and only 12.0 basis points per US dollar of deposits on average for countries that have explicit deposit insurance (panel A of Table 2). However, these averages do not differ statistically from each other because of large variations in these values within each panel of countries. Next, we use regression techniques that control for various country-specific, bankspecific, and time-specific effects to assess more accurately whether the opportunity-cost value of deposit insurance services depends on whether deposit insurance is explicit or implicit. In each regression specification, the endogenous variable is the estimated value of deposit insurance services. Mean error in measuring this variable that is orthogonal to the regressors will be absorbed into the intercept. Since the number of observations varies widely across country we employ weighted least squares to estimate the regressions models, using the inverse of the number of country observations for each country as the weight for each bank in that particular country. We also transform variables to logarithms to control for size effects. We present the regression results with White (1980) s heteroskedasticity-corrected standard errors. In each specification, we control for time-specific effects by adding year dummy variables. To control for bank-specific ownership effects we introduce a majority ownership dummy variable. The concentrated ownership dummy is one if the bank has an owner with a shareholding of 50% or more, and is zero otherwise. This bank-specific variable is also used in Laeven (2001). We also include a number of country-specific variables in the regressions to control for differences across countries. First, we add the level of GDP per capita to proxy for differences in the overall level of development of the country. We expect that the opportunity-cost value of deposit insurance services is lower when countries are more developed. Second, we control for differences in the quality and enforcement of laws across countries. We use the ICRG law and order index, which is increasing in the quality of law and order. We expect less moral hazard in countries with strong legal systems, and therefore that the opportunity-cost value of deposit insurance services is lower when countries have stronger legal systems. Next, we add a dummy variable that takes value one if the country has explicit deposit insurance, and value zero if the country has implicit deposit insurance to indicate the type of deposit insurance in 10

11 the country. Nine of the fourteen sample countries have explicit deposit insurance. The other five countries have implicit insurance. Finally, we control for government bailouts of bank liabilities. During the period , when Indonesia, Malaysia, and Thailand experienced a financial crisis, their governments guaranteed most bank deposits by issuing blanket guarantees. Although these three countries did not formally offer explicit deposit insurance at the time, one could argue that the guarantees established explicit deposit insurance during these two years (Demirgüç-Kunt and Kane (2001)). We therefore include a dummy variable that takes value one if the government of the country bails out bank creditors with a blanket guarantee of bank liabilities (including deposits), and that takes value zero otherwise. For the countries Indonesia, Malaysia, and Thailand this variable takes value one for the years 1997 and 1998, and zero in all other years. We use all these control variables to assess the effect of explicit deposit insurance and bailouts on the opportunity-cost value of deposit insurance services. Column a of Table 3 reports the coefficient estimates for this model specification. We find that the opportunity-cost value of deposit insurance is significantly higher in countries with explicit deposit insurance and in countries that announce government bailouts. These results suggests that explicit deposit insurance encourages banks to engage in risk-shifting. A Wald test of equality of the regression coefficients of the explicit deposit insurance variable and the bailout variable indicates that these two individual coefficients differ significantly. As in Laeven (2001), we also find that concentrated ownership of banks is associated with a higher opportunity-cost value of deposit insurance services. In addition, we find that the opportunity-cost value of deposit insurance services is lower in countries with strong law and order, consistent with our presumptions. However, GDP per capita is not found to have a significant impact on the opportunity-cost value of deposit insurance services. We have also explored the use of the amount of total bank loans as potential explanatory variable to control for bankspecific size effects. Because the effect of this variable on the opportunity-cost of the value of deposit insurance proved consistently negligible, we exclude this variable from the equations reported here. [Insert Table 3 here] 11

12 Research by Demirgüç-Kunt and Detragiache (1999) indicates that that the opportunity-cost value of deposit insurance services should be higher in countries that have both explicit deposit insurance and weak institutional environments. To allow for differences in the effect of explicit deposit insurance on the opportunity-cost value of deposit insurance services between countries that differ in the quality of law and order, we interact the quality of law and order and the explicit deposit insurance dummies. This expanded model is estimated in column b of Table 3. This formulation indicates that explicit deposit insurance raises the opportunitycost value of deposit insurance services, but that the presence of strong law and order reduces the adverse effects of explicit deposit insurance on the opportunity-cost value of deposit insurance services. This finding is consistent with Demirgüç-Kunt and Detragiache (1999), who provide empirical evidence that explicit deposit insurance increases banking system fragility in countries with weak institutional environments. The other results in column b of Table 3 are similar to those presented in column a of the same table, except that a Wald test of equality of coefficients of the explicit deposit insurance variable and the bailout variable now indicates that these two coefficients are not significantly different from each other. The results in Table 3 should be interpreted with caution because some of the explanatory variables are highly correlated. A further caution in interpreting our results comes from the relatively small number of countries covered. 5. Conclusions We estimate the opportunity-cost value of deposit insurance services for a large number of banks in different countries using the option-pricing technique proposed by Ronn and Verma (1986). We use these estimates to investigate the relationship between the existence of explicit deposit insurance and the opportunity-cost value of deposit insurance services, controlling for such factors as macro-environments and corporate governance structures. The presence of explicit deposit insurance is associated with a higher opportunity-cost value of deposit insurance services, but the existence of proper quality and enforcement of laws can reduce the adverse moral hazard effects on the 12

13 opportunity-cost value of deposit insurance services that arise from explicit deposit insurance. Our findings support the hypothesis that explicit governmental deposit insurance does not work well in countries with poor law and order, because they it displaces private monitoring activity with poor-quality government monitoring of bank risk-taking. Incentive problems differ in magnitude between different types of banks. Thus, our findings suggest that the value of deposit insurance depends to a large extent on a bank s institutional environment. These findings are consistent with Kane (2000) who argues that a country s financial safety net cannot be a one-size-fits all proposition, and must respond to differences in country contracting environments. These findings are important to policy makers. First, the data support the view that proper law and order is an ingredient of a sound financial system. Second, the results support the hypothesis that explicit deposit insurance should not be introduced in countries with weak institutional environments. Explicit deposit insurance, when introduced, should be credible and should not invite significant moral hazard. 13

14 Literature Allen, L. and A. Saunders (1993), Forbearance and Valuation of Deposit Insurance as a Callable Put, Journal of Banking and Finance 17, Beck, T. (2000), Deposit Insurance as Private Club: The Case of Germany, This volume. Bhattacharya, S., A. Boot, and A. Thakor (1998), The Economics of Bank Regulation, Journal of Money, Credit, and Banking 30, Bhattacharya, S. and A. Thakor (1993), Contemporary Banking Theory, Journal of Financial Intermediation 3, Black, F. and M. Scholes (1973), The Pricing of Options and Corporate Liabilities, Journal of Political Economy 81, Chan, Y.-S., S. Greenbaum, and A. Thakor (1992), Is Fairly Priced Deposit Insurance Possible?, Journal of Finance 47, Cooperstein, R., G. Pennacchi, and F. Redburn (1995), The Aggregate Cost of Deposit Insurance: A Multiperiod Analysis, Journal of Financial Intermediation 4, Cull, R., L. Senbet, and M. Sorge (2000), Deposit Insurance and Financial Development, Mimeo, World Bank. Demirgüç-Kunt, A. and E. Detragiache (1999), Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation, Policy Research Working Paper No. 2247, World Bank. 14

15 Demirgüç-Kunt, A. and H. Huizinga (1999), Market Discipline and Financial Safety Net Design, Policy Research Working Paper No. 2183, World Bank. Demirgüç-Kunt, A. and E. Kane (2001), Deposit Insurance Around the Globe: Where Does it Work?, Mimeo, World Bank. Demirgüç-Kunt, A. and T. Sobaci (2000), Deposit Insurance Around the World: A Data Base, Mimeo, World Bank. Duan, J.-C. (1994), Maximum Likelihood Estimation Using Price Data of the Derivative Contract, Mathematical Finance 4, Duan, J.-C. (2000), Correction: Maximum Likelihood Estimation Using Price Data of the Derivative Contract, Mathematical Finance 10, Duan, J.-C. and M.-T. Yu (1994), Assessing the Cost of Taiwan s Deposit Insurance, Pacific-Basin Finance Journal 2, Fama, E. E. (1965), The Behavior of Stock-Market Prices, Journal of Business 38, Fries, S., R. Mason, and W. Perraudin (1993), Evaluating Deposit Insurance for Japanese Banks, Journal of the Japanese and International Economy 7, Garcia, G. G. (2000), Deposit Insurance : Actual and Good Practices, Occasional Paper No. 197, International Monetary Fund. Hovakimian, A. and E. Kane (2000), Effectiveness of Capital Regulation at U.S. Commercial Banks, 1985 to 1994, Journal of Finance 55, Kane, E. (1995), Three Paradigms for the Role of Capitalization Requirements in Insured Financial Institutions, Journal of Banking and Finance 19,

16 Kane, E. (2000), Designing Financial Safety Nets to Fit Country Circumstances, Mimeo, Boston College. Kaplan, I. (1998), The Put Option Approach to Banking Crises in Emerging Markets: Valuing Implicit Deposit Insurance in Thailand, Mimeo, University of Washington. Laeven, L. (2001), Bank Risk and Deposit Insurance, Forthcoming in World Bank Economic Review. Marcus, A. and I. Shaked (1984), The Valuation of FDIC Deposit Insurance Using Option-Pricing Estimates, Journal of Money, Credit, and Banking 16, Merton, R. (1977), An Analytical Derivation of the Cost of Deposit Insurance and Loan Guarantees, Journal of Banking and Finance 1, Merton, R. (1978), On the Cost of Deposit Insurance When There Are Surveillance Costs, Journal of Business 51, Pennacchi, G. (1987a), A Reexamination of the Over- (or Under-) Pricing of Deposit Insurance, Journal of Money, Credit, and Banking 19, Pennacchi, G. (1987b), Alternative Forms of Deposit Insurance: Pricing and Bank Incentive Issues, Journal of Banking and Finance 11, Ronn, E. and A. Verma (1986), Pricing Risk-Adjusted Deposit Insurance: An Option- Based Model, Journal of Finance 41, Saunders, A. and B. Wilson (1995), If History Could Be Rerun: The Provision and Pricing of Deposit Insurance in 1933, Journal of Financial Intermediation 4,

17 White, H. (1980), A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity, Econometrica 48,

18 Table 1: Features of deposit insurance systems. Country Type Established Membership Insurance premium Argentina Explicit 1979 Compulsory % (risk-based) Chile Explicit 1986 Compulsory Callable France Explicit 1980 Compulsory Callable, but limited Germany Explicit 1966 Compulsory 0.03 %, but can be doubled Hong Kong Implicit Indonesia Implicit Japan Explicit 1971 Compulsory 0.04 % Korea Explicit 1996 Compulsory 0.05 % Malaysia Implicit Singapore Implicit Taiwan Explicit 1985 Compulsory (Proposed) % Thailand Implicit - - UK Explicit 1982 Compulsory On demand (maximum of 0.3 %) US Explicit 1934 Compulsory % (risk-based) Notes: For the sample of countries we list whether the country has explicit or implicit deposit insurance. If the country has explicit deposit insurance then we report the date when it was established, whether participation is compulsory or voluntary, and the level of the annual insurance premium (as a % of insured deposits). Korea had implicit deposit insurance before The data are taken from Demirgüç-Kunt and Sobaci (2000) and Garcia (2000). 18

19 Table 2: Official premiums versus opportunity-cost values of deposit insurance (in basis points per US dollar). Panel A: Explicit Deposit Insurance Country Official Premium Value of Deposit Insurance Standard Deviation Observations Argentina Chile Callable France Callable Germany Japan Korea Taiwan UK < US Average Panel B: Implicit Deposit Insurance Country Official Premium Value of Deposit Insurance Standard Deviation Observations Hong Kong Indonesia Malaysia Singapore Thailand Average Panel C: All countries Country Official Premium Value of Deposit Insurance Standard Deviation Observations Average Notes: The column for official premiums reports the insurance premiums actually charged in countries with explicit deposit insurance. These premiums are taken from Demirgüç-Kunt and Tobaci (2000). The column for deposit insurance value reports the average value of deposit insurance for each country over all banks and across all years. The value of deposit insurance is calculated over the period using the Ronn and Verma (1986) method. The columns labeled standard deviations and observations report the standard deviations of the average values of deposit insurance and the number of datapoints in each country. 19

20 Table 3: Value of deposit insurance under alternative deposit insurance arrangements Explicit (a) Explicit and Law (b) Majority ***.641 ***.540 (.133) (.130) GDP per capita (.073) (.070) Law and Order *** *** (.523) (.429) Explicit ***.343 ***2.891 (.116) (.512) Bailout ***2.180 ***2.337 (.243) (.244) Law and Order * Explicit ***-.510 (.095) Adjusted-R Obs Wald test of equality of coefficients for Explicit and Bailout *** Notes: Dependent variable is ln(1+value), where Value is the opportunity-cost value of deposit insurance services in basis points per US dollar of deposits calculated using the method of Ronn and Verma (1986). Majority is a bankspecific dummy variable that takes value 1 if the bank has a majority owner that owns % of the shares in the bank, and 0 otherwise. GDP per capita is the logarithm of the level of GDP per capita in US dollars. Law and Order is the logarithm of the Law and Order index of the Political Risk Services group which ranges from 0 to 6 (6 indicating an excellent system of law and order). Explicit is a dummy variable that takes value 1 if the country has explicit deposit insurance, and 0 otherwise. Law and Order* Explicit is an interaction term of the Explicit and Law and Order variables. Bailout is a dummy variable that takes value 1 if the government bails out bank creditors by issuing blanket guarantees, and 0 otherwise. Models (a) and (b) control for concentrated ownership, GDP per capita, the quality of the legal system, the existence of explicit deposit insurance, and the announcement of government guarantees on bank liabilities. In addition, model (b) adds an interaction term between the quality of legal system and the existence of explicit deposit insurance. All models are estimated using weighted least squares, with weights equal to the inverse of the number of country observations. A constant term and year dummies were added to all regression specifications, but are not reported. The last row presents a Wald covariance-test of individual coefficient differences. Heteroskedasticityconsistent standard errors are in parentheses. *** indicates significance at 1% level ** indicates significance at 5% level * indicates significance at 10% level. 20