Market discipline and deposit insurance reform in Japan

This paper examines the relationship between market discipline and the deposit insurance system in Japan using unique data set on bank-level weekly deposit rates in Japan. I find that when the government provided an unlimited coverage for all bank deposits, the risk profile of banks had no effect on either interest rates of deposits or the quantity of deposits. That is, depositors failed to monitor and punish risky banks. On the other hand, when the government imposed an insurance limit on time deposits, 10 million yen (approximately $100,000) per depositor per bank, risky banks started offering higher interest rates on time deposits and attracting less time deposits than financially strong banks. In addition, as expected, the interest rates differential between partially insured time deposits and fully insured ordinary deposits increased for financially weak banks. These two pieces of evidence indicate the emergence of market discipline. However, after the reform, the implicit guarantee provided by the government became a more important determinant of interest rates and deposit growth, thereby partially offsetting the positive effects of deposit insurance reform on market discipline. Because of this implicit guarantee, overall effects of deposit insurance reform on market discipline are likely to be small.