Sovereign distress and the credibility of deposit insurance

Deposit insurance arrangements are crucial to mitigate the likelihood of bank runs. However, the success of these protection schemes depends on their credibility, which explains why they are usually guaranteed by the sovereign. But what happens when the sovereign is also in distress? Can the sovereign backstop actually weaken the credibility of deposit insurance mechanisms in some circumstances?

This paper examines two episodes that occurred during the euro area sovereign debt crisis (2010-2013) to better understand the role of the credibility of the sovereign backing the deposit insurance arrangements.

First, the paper studies how depositors reacted to the decision of some of the foreign banks active in Portugal to change their legal status from a subsidiary to a branch during this period. While subsidiaries of foreign banks offer their depositors the insurance of the host country, branches offer their depositors the insurance coverage of the country of their parent bank. This change in status implies that the protection of deposits became the responsibility of the country of origin of that banking group. The paper finds that depositors react to this change, increasing their deposits in these financial institutions (despite the fact that they were offering much lower deposit interest rates in that period).

Second, the paper investigates Portuguese depositors’ response to an increase in uncertainty on the level of insurance coverage following the announcement of the Cypriot financial assistance program. Initially, the program was designed in a way that even depositors covered by the Cypriot guarantee fund would lose part of their savings. This decision was soon reversed, but the paper finds that the uncertainty generated around this event was enough to change deposit allocation decisions in Portugal. Depositors moved their deposits into banks that were less susceptible to that uncertainty, i.e. branches of foreign banks from financially sound countries.

These results show the importance of the credibility of deposit guarantee arrangements to ensure financial stability, identifying a new channel of sovereign-bank links that may be at work during crises.

Click here to go to the paper by Diana Bonfim and João A. C. Santos.