Do banks increase their risk-taking when deposit insurance is introduced?

Banks' risk-taking behavior is at the core of the discussions about the current financial turmoil. The regulatory obligations to which banks are subject is known to have a great influence on their behavior but what about pieces of legislation that primarily concern their depositors? In a recent discussion paper, TILEC member María Fabiana Penas and co-author Vasso P. Ioannidou (Tilburg University) study the effect of the introduction of a generous deposit insurance system on banks' risk-taking behavior. Using detailed credit registry data from Bolivia, a
country which introduced a deposit insurance system in 2001, they compare the risk-taking behavior of banks before and after the change. They find that in the post-deposit insurance period, banks were more likely to initiate riskier loans (i.e., loans with worse ratings at origination). These loans carried higher interest rates and were associated with worse ex-post performance. The authors' results also suggest that this increase in risk-taking was due to the drop in market discipline from large depositors, and that differences between large (too-big-to-fail) and small banks diminished in the post-deposit insurance period.