Deposit Insurance and Depositor Behavior: Evidence from Colombia

One of the achievements that earned Douglas Diamond and Philip Dybwig the 2022 Nobel Prize in Economics (jointly with Ben Bernanke) was a model of bank withdrawals and related financial crises. In an article published in 1983, they noted that in the 1930s in America, people cashed out their savings as soon as rumors about a bank’s financial condition began to spread, lest the bank fail and they lose their money . Such bank runs, however, were the reason many otherwise healthy banks collapsed during those years. State-guaranteed deposit insurance, the Nobel laureates concluded, is the best solution to this problem.

Nicola Limodio (Bocconi Department of Finance), in a forthcoming paper with Nicolas De Ru (University of the Andes), found that deposit insurance motivates people to hold deposits just below the insurance threshold (‘bundling’ behavior) and that increasing the insured amount causing savers and especially poolers to change their asset allocation and increase their deposits. The authors were able to estimate the elasticity of deposits with respect to insurance; in their case, a 1% increase in the share of insured deposits translates into 2.3% additional deposits. The findings are published in The Review of Financial Research diary.

The effect of changes in deposit insurance on depositor behavior is difficult to observe because the threshold is usually raised in the event of a financial crisis, when the effect of the policy change cannot be distinguished from the effects of other economic forces. In times of financial difficulty, individuals may change their deposit behavior for reasons unrelated to changes in the insurance threshold.

However, in April 2017, the Colombian Deposit Guarantee Fund increased the insurance for individual deposits from 20 million Colombian pesos (COP) (approximately USD 6,780) to 50 million COP (approximately USD 16,950). The change is unexpected and is motivated solely by the need to update the real value of the insurance threshold, which has not been changed since 2000.

“We partnered with a major bank in Colombia and obtained two years of monthly records of individual deposits for more than 50,000 individuals,” Professor Limodio said. “We observed that more than 40% of savers showed group behavior and that they increased the level of their deposits after the threshold change much more than those with already higher deposits.”

The driver of this effect was an increase in the expected return on deposits, which led people to substitute other assets to increase savings.

“Deposit insurance is an effective form of regulation,” commented Prof. Limodio, “but it creates costs because it encourages moral hazard behavior by banks and increases risk-taking by the financial system as a whole. These costs and benefits must be weighed to determine the optimal level of deposit insurance. Therefore, understanding the channels through which insurance promotes deposits and assessing its causal effect on depositor behavior is critical.”