Deposit insurance boosts bank stability in Africa
A new working paper from the Centre for Responsible Banking and Finance at the University of St Andrews Business School challenges a long-held assumption in banking regulation: that more generous deposit insurance makes financial systems less stable.
The paper, part of the Centre’s Working Paper Series, covers 54 African countries from 2000 to 2021. It finds that countries with higher deposit insurance coverage had more stable banking systems, which runs counter to evidence from the United States and Europe, where generous guarantees have often been linked to excessive risk-taking by banks.
Deposit insurance is a government-backed guarantee that returns savers’ deposits, up to a set limit, if their bank fails. It is designed to prevent bank runs, in which mass withdrawals by panicked customers can destroy an otherwise healthy institution within days, as the 2023 collapse of Silicon Valley Bank showed.
Critics, however, argue that the guarantee creates a different problem. When depositors know their money is safe, they have less reason to scrutinise how their bank is run. Banks, freed from that pressure, may take on excessive risk. Economists call this moral hazard, and it has driven much of the scepticism around deposit insurance in the academic literature.
The paper was co-authored by the Business School’s Dr Linh Nguyen, Dr Anna Sobiech and Professor John Wilson and Lechedzani Kgari of the Bank of Botswana’s Prudential Authority and Payments Oversight Department.
Dr Nguyen said:
“Our findings challenge the assumption that deposit insurance necessarily encourages reckless behaviour by banks. In African banking systems, where depositors have limited means to monitor their banks and economic conditions are often volatile, the stabilising effect of deposit insurance appears to outweigh the risks of moral hazard.”
The researchers identified two mechanisms behind the stabilising effect. More generous coverage was associated with less volatile bank earnings and with reduced lending, particularly to the private sector. Rather than expanding into riskier territory, banks appeared to consolidate their balance sheets. The authors argue that this points to conservative financial management rather than the moral hazard the critics predict.
The findings carry implications for policymakers beyond Africa. As regulators in the United Kingdom and elsewhere revisit the design of deposit protection following the 2023 banking turmoil, the research suggests that the effects of deposit insurance are context-dependent. The institutional environment in which a scheme operates matters as much as the scheme itself.