Coverage Levels in Deposit Insurance: to Increase or not to Increase

Abstract

This paper studies the impact on welfare of changes in coverage levels within deposit insurance
schemes. The paper builds on previous literature by adding the possibility of bailouts for too-big-to-
fail banks and incorporating a time lag between deposit payout and recoveries. Banks are also
allowed to adjust deposit rates, and I include the effect this has on welfare. I show how to link
theoretical results in this expanded model to observable variables, and I apply it to Colombia’s
2017 increase in its coverage level. I estimate all the model’s parameters from data and calculate
the impact on welfare of this increase in coverage. Benefits outweigh costs, although the net effect
is modest in size and sensitive to some of the parameters. Key variables are size, the probability
of default and the impact the change in the coverage level has on the amount of insured deposits.
Bailouts have mixed effects but overall raise the costs of increasing coverage levels. So does including a time lag between payout and recoveries. Allowing banks to adjust deposit rates also leads to larger costs because of higher deposit rates.