Did Deposit Insurance Reforms Improve Liquidity Creation? Evidence from Indian Banking

Abstract The role and relevance of deposit insurance as a mechanism to safeguard banking stability have been well recognised in the literature. However, little is known about whether and how such deposit insurance reforms affect bank liquidity creation. To inform this debate, we exploit the upward revision in the deposit insurance coverage for depositors in India in February 2020 and tease out the causal impact. The findings reveal that deposit insurance reforms increased liquidity creation for banks with a high capital buffer, consistent with the risk absorption hypothesis. The impact was primarily evident on the asset side and less pronounced on the liability side or off-balance sheet activities. Robustness tests reinforce these findings.