In December 2025, deposit insurance protection in the UK rose from £85,000 to £120,000. This means that if you hold savings with a UK bank and the bank fails, the government protects your money up to that limit.
That is clearly good news for depositors. But what about banks? My research shows that deposit insurance can be a double-edged sword. It can either encourage excessive lending or discourage banks from lending altogether.
Deposit insurance and bank lending
Deposit insurance acts like a subsidy that makes money cheaper for banks. But this only helps if a bank can actually get more deposits from regular people. If a bank has plenty of these cheap insured deposits, it tends to lend too much. It might even fund bad loans because the money it is using is so cheap.
This is the usual concern that people have about deposit insurance: they worry that it encourages banks to lend too much or take too much risk. But it is only half the story.
Banks cannot always keep attracting more deposits. Deposits are often sticky, and their supply is not unlimited. Once a bank has reached the point where it cannot easily bring in more deposit funding, it must look elsewhere.
Banks that run out of deposits must then borrow from big, professional investors in the wholesale market. These investors know that if the bank fails, the government protects you and your savings first. Because they are last in line to get paid, they demand much higher interest rates. Banks using wholesale funding as the marginal funding source may pass up good, profitable loans because the marginal cost of borrowing is simply too high.
In my work, I find evidence for this pattern in data on US banks and mortgage lending. Banks that rely more on deposits tend to expand lending when they have more insured deposits. Banks that rely more on market funding tend to pull back instead. So, the same increase in insured deposits can lead to opposite outcomes across banks.
The effects of higher deposit protection on credit
My research helps us to understand why the economy is sometimes starved of credit even when the banking system seems stable. For decades, researchers focused almost entirely on banks being too aggressive due to deposit insurance. But I show that what’s known as the overhang problem – where banks lend too little – is just as dangerous.
We saw this in action during the 2023 regional banking crisis in the United States. When depositors moved their money out of certain banks, many institutions suddenly lost their cheap funding and were forced to rely on expensive market sources. As my analysis predicts, these banks immediately began to reduce their lending.
This wasn’t just a temporary panic. I find that the drop in lending persisted long after the initial crisis ended. This tells us that the way in which we provide deposit insurance has a direct impact on the real world. It affects whether a small business can get a loan to expand or whether a family can get a mortgage. If we only look at the reckless side of bank behaviour, we miss the fact that our safety net might be making credit too expensive for many parts of the economy.
Next steps for policy-makers
My findings suggest that policy-makers and researchers should rethink how deposit insurance and bank regulation work together. In the UK, deposit protection is provided through the Financial Services Compensation Scheme.
Under the FSCS, banks do not all pay the same flat fee. Charges depend in part on the level of protected deposits that they hold and on a set of risk indicators, such as capital, liquidity, bad loans, profitability and the ratio of unencumbered assets to covered deposits.
So the system is not purely ‘one size fits all’. At the same time, it still does not directly capture the issue at the heart of my research – how much a bank depends on market funding when it wants to make one more loan.
That is where the right policies could help. A bank that can still fund itself mainly with insured deposits faces very different incentives from a bank that has to rely on wholesale investors. Yet the current fee framework does not clearly distinguish between those two cases.
My results suggest that deposit insurance fees should pay more attention to banks’ funding mix, not just their overall balance sheet risk. Put differently, regulation should ask not only ‘how risky is this bank?’, but also ‘from where will its next pound of lending be funded?’ That would make the price of deposit insurance better reflect the real distortions that it can create.
A second lesson for policy-makers is that they should think more carefully about how different rules interact. Deposit insurance cannot be designed in isolation. Capital rules matter too.
Requiring banks to fund themselves with more capital can help in two ways. First, it reduces the temptation to take excessive risks when insured deposits are cheap. Second, it can reassure market investors when a bank relies on wholesale funding, which can lower funding costs and support lending.
In that sense, stronger bank capital can lean against both over-lending and under-lending. The Bank of England’s broader financial stability framework is built around exactly this idea: banks should be resilient enough to absorb shocks and still support households and businesses.
Finally, the rules for dealing with bank failure need to remain credible. Deposit insurance works best when small savers are protected, but shareholders and investors still expect to bear losses if and when a bank fails. If markets believe that the government will step in and protect everyone, then market discipline weakens. But if the limits of protection are clear and resolution is credible, investors have a reason to price risk properly without triggering panic.
