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Flight from Safety: How a Change to the Deposit Insurance Limit Affects Households’ Portfolio Allocation

Evren Damar, Reint Gropp () and Adi Mordel

Staff Working Papers from Bank of Canada

Abstract: Deposit insurance protects depositors from failing banks, thus making insured deposits risk-free. When a deposit insurance limit is increased, some deposits that previously were uninsured become insured, thereby increasing the share of risk-free assets in households’ portfolios. This increase cannot simply be undone by households, because to invest in uninsured deposits, a household must first invest in insured deposits up to the limit. This basic insight is the starting point of the analysis in this paper. We show that in a standard portfolio allocation model, faced with a deposit insurance limit increase, households move some of their assets out of deposits into risky alternatives, such as mutual funds. Our empirical analysis, taking advantage of a deposit insurance increase in Canada in 2005 and detailed household portfolio data, confirms the insights from the model and stands up to multiple alternative explanations. Hence, we show that an increase in the deposit insurance limit results in a sizable deposit outflow. Our work has important policy lessons. First, although there is considerable evidence on the financial stability consequences of deposit insurance (as it reduces the impact of runs in a crisis), we document a novel implication where enhanced protection may also trigger deposit outflows during non-crisis times. Second, the paper highlights the link between deposit insurance and the composition of household portfolios. It emphasizes the role that uninsured deposits play in the household investment decision and the importance of studying them separately from insured deposits when analyzing portfolio allocation choice.

Keywords: Financial Institutions; Financial system regulation and policies (search for similar items in EconPapers)
JEL-codes: D14 G21 G28 L51 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-cba, nep-ias and nep-rmg
Date: 2019-08
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