Deposit insurance increase and risk taking by banks

This paper examines the effect of the 150% increase in deposit insurance coverage in 1980 on risk taking by banks in the U.S. The analysis is potentially relevant since recently there have substantial increases in deposit insurance coverage in many countries that are comparable in magnitude to the increase in U.S. deposit insurance earlier. It is found that the jump in deposit insurance coverage is associated with banks taking more risk. The absolute value of the negative correlation between market value of assets/book value of assets and three measures of bank risk - systematic, unsystematic and total - is significantly increased subsequent to the increase in deposit insurance coverage. Risk taking is positively associated with bank size and significantly more so following increase in deposit insurance coverage. It can be argued that appropriate policy associated with an expansion of deposit insurance coverage include steps to adequately capitalize banks, with tightening of bank capital requirements to mitigate the potential costs of greater risk with greater coverage, and increased monitoring of bank activity, particularly that of large institutions. Estimation of panel data is with fixed effect estimation corrected with heteroskedasticity robust variance matrix of estimates.