DEPOSIT INSURANCE AND EXTERNAL FINANCE

I. INTRODUCTION Capital markets serve an essential purpose in the growth and development of modern economies. They provide for the efficient channeling of funds from savers to investors. There are two basic methods for financing capital investment: primary issuance of equity or bonds, and securing of bank loans. Looking around the world, we see that countries differ substantially in the relative importance of banks and capital markets in providing investment financing. Equity market capitalization currently ranges from close to zero in countries like Austria, Argentina, and Greece to nearly two times gross domestic product (GDP) in the United Kingdom, South Africa, and Malaysia. The importance of bank loan financing is essentially the mirror image of this. What accounts for the cross-country differences in the importance of banks and capital market financing of investment? The purpose of this article is to address this question directly. We contend that much of the variation across countries in the depth and breadth of capital markets can be explained by a combination of the existence of deposit insurance and the extent to which a country's banking system is state-owned. Because of the importance of financial intermediation, and the difficulties associated with potential bank failures, governments in most countries have established a set of institutional structures to ensure the stability of their banking systems. Primary among these is the creation of deposit insurance. By insuring deposits, banks' liability holders are significantly less likely to request the return of callable deposits, reducing the chances of bank runs. But at the same time, deposit insurance subsidizes bank risk-taking activities and allows the payment of lower interest rates to depositors. (1) This channels money through banks and away from financial markets. Direct state bank ownership has a similar impact (see Barth et al. 2001; La Porta et al. 2000). We present a simple, three-sector model, in which the economy is composed of firms, banks, and households. The firms require operating capital and can obtain it either through equity issuance or from bank loans. Banks take deposits from households and make loans to firms, while households both allocate their wealth and purchase the firms' output. The model allows us to show how increases in deposit insurance (or the percentage of the banking system that is state-owned) both reduces the size of the capital market and shrinks the amount of bank credit to the private sector and may decrease the number of firms seeking equity financing. To examine the predictions of the model, we study a data set composed of 49 countries. Of these, 33 currently have explicit deposit insurance and 42 have some state ownership of banks, ranging from less than 2% to almost 90%. The data confirm the predictions of the model. An increase in either state bank ownership or presence of deposit insurance both decreases the size of capital markets and the extent of bank lending. For example, we would predict that decreasing the percentage of the banking system that is state-owned from 36%, as it is in Italy, to zero would increase in the size of the capital market from less than 10% to over 30% of GDP and a raise in the level of bank lending from 57% to close to 90% of GDP. Our conclusions are in contrast with those in La Porta et al. (1997), who study the relationship between law and finance. La Porta et al. note the importance of the countries' legal system in determining the structure of the financial system. In particular, they point out that investors provide capital to firms only if they believe they will get their money back. For equity holders, this means that they must be able to vote out directors and managers who do not pay them. For creditors and holders of bonds, this means that they must have authority to repossess collateral. Furthermore, these nominal legal rights must be accompanied by confidence that the laws will be enforced. …