Center for Economic Institutions Working Paper Series How Country and Safety-Net Characteristics Affect Bank Risk-Shifting Working Paper Series How Country and Safety-Net Characteristics Affect Bank Risk-Shifting * How Country and Deposit Insurance Charac

Abstract: Risk-shifting occurs when creditors or guarantors are exposed to loss without receiving adequate compensation. This project seeks to measure and compare how well authorities in 56 countries controlled bank risk shifting during the 1990s. Although significant risk shifting occurs on average, substantial variation exists in the effectiveness of risk control across countries. We find that the tendency for explicit deposit insurance to exacerbate risk shifting is tempered by incorporating loss-control features such as risksensitive premiums, coverage limits, and coinsurance. Introducing explicit deposit insurance has had adverse effects in environments that are low in political and economic freedom and high in corruption. March 21, 2002 How Country and Deposit Insurance Characteristics Affect Bank Risk-Shifting Credible deposit insurance offers benefits to short-horizoned policymakers and politicians. It can eliminate the threat of depositor runs and protect small depositors without its full economic cost immediately registering on the government budget. Part of the cost of deposit insurance is that it reduces incentives for depositors to monitor and police their banks. In countries that have not introduced deposit insurance explicitly, insurance is implicit. The costs and benefits society experiences from either type of guarantees depend on how effectively government regulators can control bank riskshifting (Buser, Chen, and Kane, 1981; Brickley and James, 1988; Calomiris, 1992; Kane, 1995; Honohan and Klingebiel, 2001). Risk-shifting occurs whenever a contractual counterparty is exposed to loss from fraud, leverage or earnings volatility without being adequately compensated for the risk entailed. Other things equal, a bank can shift risk onto its deposit insurer in two principal ways: by increasing its leverage and by increasing the volatility of its return on assets. Risk-shifting is subsidized whenever the value of the explicit and implicit deposit guarantees a country's banks enjoy exceeds the implicit and explicit premiums the insurer imposes on them. To avoid subsidizing bank risk taking, a deposit insurer must monitor and police both activities appropriately. The empirical literature on bank risk-shifting begins with Marcus and Shaked (1984). They use a one-year put option model to estimate a risk-adjusted "fair" value for a bank's deposit insurance premium. The authors find that on average FDIC insurance 1 was overpriced, but that the distribution of fair premiums was strongly skewed to the right. Using improved one-period model of Ronn and Verma (1986) This paper analyzes cross-country differences in bank risk-shifting behavior. Kane (2000) argues that the design of a country's financial safety net should take country-specific factors into account: differences in informational environments and in the enforceability of private contracts in particular. Demirgüç-Kunt and Kane (2002) contend that explicit deposit insurance should not be adopted in countries with a wea