Deposit insurance, market discipline and moral hazard problem: the case of Turkish banking system

Abstract

This paper analyzes the effects of deposit insurance system on the financial performance of Turkish commercial banks using experimental design approach. The research findings provide support to moral-hazard hypothesis. My findings indicate that domestic private commercial banks show significant increases in credit risk, foreign exchange position risk, liquidity risk, and agency costs relative to their benchmark after introduction of 100 percent deposit insurance system. I relate this excessive risk-taking to the moral-hazard behavior by commercial banks. The smaller commercial banks which are more vulnerable to moral-hazard problem experience significant increases in agency costs. The research results indicate that 100 percent deposit insurance system distorts the incentive structure of commercial banks and thus, prevent proper functioning of market discipline mechanism and lead to the taking excessive risk-taking. I also analyze the efficiency of market discipline mechanism by examining market reaction to the four failed banks transferred to SDIF. The research findings show that the cumulative abnormal returns of failed banks reflected unfavorable information 45 weeks prior to the beginning of the bank examination and 65 weeks prior to the transfer of the failed bank to SDIF. Thus, the hypothesis that market is inefficient and do not properly react to the increased potential of bankruptcy is not supported