The primary objective of this paper is to investigate the impact of moral hazard on the
effectiveness of deposit insurance in achieving banking stability. If moral hazard explains
banking instability arising from the adoption of deposit insurance, then deposit insurance
will be associated with bank insolvency more than with bank runs. To test the hypothesis, we
develop a new empirical framework distinguishing between banking instability initiated by
panic withdrawals of deposits, and banking instability initiated by the insolvency problem
of banks. Using a dataset covering 118 countries over the period 1980-2004, we find that
deposit insurance per se has no significant effect either on bank insolvency or on bank
runs. However, interacting deposit insurance with credit to the private sector, we observe
a positive and significant effect on bank insolvency and bank runs, suggesting that moral
hazard outweighs the positive effect of deposit insurance on banking stability.
JEL classification codes: G21, G28, E44
Key words: banking crises, deposit insurance, moral hazard