Bank runs and deposit insurance in developing countries: The case of Turkey

The purpose of this dissertation is to address the policies intended to minimize risks and consequences of banking crises and bank runs in developing countries in the context of a developing country, Turkey. The first part of the study empirically investigates reasons of bank failures in Turkey. The main hypothesis of the investigation is that the presence of full coverage deposit insurance after 1994 worsened the financial position of banks in Turkey through moral hazard and adverse selection. This hypothesis examined by a two stage empirical approach. In the first stage, by constructing a probit model, the author analyzed determinants of privately-owned commercial bank failures in Turkey. In the second stage, the author investigated the effects of moral hazard and adverse selection problems of full coverage deposit insurance on the financial ratios of the Turkish banking sector by evaluating pre-1994 and post-1994 benchmark-adjusted financial ratios using nonparametric Wilcoxon signed rank test. Our empirical investigation reveals that bank failures in Turkey are positively and strongly correlated with the presence of full coverage deposit insurance. The presence of full coverage deposit insurance after 1994 led to deteriorations in financial ratios of especially small banks, suggesting increased fragility in the Turkish banking sector through moral hazard and adverse selection. These results may suggest that it would be preferable to remove deposit insurance in order to minimize bank failures in Turkey. By looking at the recent bank run on the SFHs in February 2001, the second part of the study analyzed the suggestion above. Our micro-study demonstrates that removal of deposit insurance coverage can exacerbate problems with widespread bank runs since depositors, especially small ones, do not appear to be able to distinguish between solvent and insolvent banks during a bank run in Turkey. Thus, we conclude that we need at least limited coverage to protect unsophisticated small depositors. Our case study also illustrates that foreign partnership in the banking sector can potentially be of great value in reducing the probability of banking crises and to overcoming depositors' runs on otherwise healthy institutions in developing countries.