Depositors' selection of banks and the deposit insurance system in Japan: Empirical evidence and its policy implications

This paper studies market discipline on banks by depositors in Japan. We stress the importance of depositors' selection of banks, which together with regulatory and supervisory schemes can strengthen corporate governance in banking. The effectiveness of depositor discipline is, however, weakened by the existence of a deposit insurance system. In order to examine the effectiveness of depositor discipline in Japan, we used a sample of 120 banks during the period FY 1998 to FY 2001, and found that the depositors' tendency to select banks based on asset risk exposure clearly strengthened ahead of the partial lift of the freeze on the payoff system (April 2002). At the same time, depositors, expecting "too-big-to-fail" policy by the government, tended to opt for larger banks regardless of their risk exposures and performance. The latter selection mechanism, however, would not offer good discipline on banks. Makeshift solutions for containing banking crises such as delaying the full introduction of the payment system and promoting bank mergers may invite further moral hazard among banks and potentially lead to destabilization of the financial system.