Bank Stability versus Financial Development: A Generous Deposit Insurer's Dilemma

This study uses Brazil as a laboratory to evaluate the effect of increasing the deposit insurance coverage limit, on bank stability and financial development. It uses a unique dataset that accounts for the multidimensional nature of financial development by capturing accessibility, depth and efficiency in financial markets and institutions. The empirical analysis utilises the synthetic control method to address the ambiguity concerns of choosing a comparison unit. In addition to estimating the effect of the policy interventions, the method creates an algorithm to identify a weighted combination of countries that have similar characteristics to Brazil. The countries are used as control units to set up a simulation that is reflective of the hypothetical absence of the policy intervention. The results suggest that increasing the coverage limit induces a trade-off between bank stability and financial development. More specifically, a generous deposit insurance supports financial development at the cost of bank stability, during the non-crisis period. However, when there is an economic crisis, the stabilising effect of deposit insurance dominates the moral hazard effect.