Deposit guarantee arrangements are a pillar of financial stability, mitigating the likelihood of runs on deposits. However, the success of these protection schemes depends on their credibility, which explains why they are usually guaranteed by the sovereign. This implies that when the sovereign is in distress, depositors may question the protection of their savings. This suggests that sovereign-bank diabolic loops may be at work also through deposit guarantee systems.

During the euro area sovereign debt crisis (2010-2013), there were two episodes allowing this hypothesis to be empirically tested. First, some of the foreign banks active in Portugal decided to change their legal status from a subsidiary to a branch during this period. This change implies that the protection of deposits becomes the responsibility of the country of origin of that banking group. We find that depositors react to this change, increasing their deposits in these financial institutions (despite the fact that they were offering much lower deposit interest rates, in that period). Second, similar reallocations were observed again following the announcement of the Cyprus financial assistance program. Initially, the program was designed in a way that even depositors covered by the Cypriot guarantee fund would lose part of their savings. This decision was soon reversed, but the uncertainty generated around this event was enough to change deposit allocation decisions in Portugal. These results show the importance of the credibility of deposit guarantee arrangements to ensure financial stability, identifying a new channel of sovereign-bank links that may be at work during crises. 

For more details see Bonfim and Santos (2020), “The importance of deposit insurance credibility”, published as Banco de Portugal Working Paper 2020-11.

Prepared by Diana Bonfim and João A.C. Santos. The analyses, opinions and findings expressed above represent the views of the authors and not necessarily those of Banco de Portugal, the Eurosystem, the Federal Reserve Bank of New York or the Federal Reserve System.

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