ALEXEI KARAS WILLIAM PYLE KOEN SCHOORS Deposit Insurance, Banking Crises, and Market Discipline: Evidence from a Natural Experiment on Deposit Flows and Rates Using evidence from Russia, we carry out what we believe to be the lit- erature’s cleanest test of the direct impact of deposit insurance on market discipline and study the combined effect of a banking crisis and deposit insurance on market discipline. We employ a difference-in-difference esti- mator to isolate the change in the behavior of a newly insured group (i.e., households) relative to an uninsured “control” group (i.e., firms). The sen- sitivity of households to bank capitalization diminishes markedly after the introduction of deposit insurance. The traditional wake-up call effect of a crisis is muted by this numbing effect of deposit insurance. JEL codes: E65, G21, G28, P34 Keywords: deposit insurance, market discipline. A PARTICULAR CHALLENGE FACING the architects of modern fi- nancial safety nets lies in the possibility that measures taken to mitigate bank failures might also weaken other forces contributing to banking sector stability (Calomiris 1999). The introduction of explicit deposit insurance presents just such a dilemma. Its potential for stabilizing economies by limiting bank runs helps explain its ubiquity across OECD countries and its spread in recent years to remote corners of the devel- oping world (Demirg¨ uc ¸-Kunt and Kane 2002). 1 But if insurance numbs depositors to the consequences of institutional failure, the disincentives of their banks to engage in ALEXEI KARAS is an Assistant Professor in the Social Science Department, Roosevelt Academy (E-mail: a.karas@roac.nl). WILLIAM PYLE is an Associate Professor in the Economics Department, Middlebury College (E-mail: wpyle@middlebury.edu). KOEN SCHOORS is a Professor at CERISE, Ghent University, and BOFIT, Bank of Finland (E-mail: koen.schoors@ugent.be). Received March 7, 2011; and accepted in revised form April 2, 2012. 1. The United States introduced the first national system of deposit insurance in 1934. Recent years have witnessed a particularly rapid expansion in its use. In 1995, 49 countries offered explicit deposit insurance; by 2003, this number had grown to 87 (Demirg¨ uc ¸-Kunt, Kane, and Laeven 2008). Journal of Money, Credit and Banking, Vol. 45, No. 1 (February 2013) C  2013 The Ohio State University