When is it desirable? How to make it work
In recent years, banking instability has emerged as a major problem in the developing world, prompting the search for ways to protect savers and ensure the viability of banking systems. The distress in the banking systems of many countries now appears to have reached unprecedented levels. It is not unusual for banks in some developing countries to have nonperforming loans that exceed 50 percent of the bank’s loan portfolio and several times the bank’s capital and reserves. The causes of this considerable distress include: (1) severe external macroeconomic shocks; (2) distortions arising from inappropriate domestic monetary and fiscal policies; (3) rapid liberalizations that have inflicted large losses on bank borrowers; and (4) imprudent policies and fraudulent behavior by bank management.
In response to these highly unstable conditions, governments in some countries have taken a variety of actions to restore their banking systems to health. These actions include: tightening banking laws and regulations designed to constrain undue bank risk taking and inappropriate insider dealings; upgrading bank supervision and examination systems; providing liquidity through the central bank to prevent bank illiquidity problems from turning into insolvencies; and intervening to resolve failing bank situations.
Some developing countries have also established deposit insurance systems to guarantee the nominal value and liquidity of deposits up to a certain size. The insurer is generally, but not always, a government-owned institution, funded with premiums paid by the institutions whose deposits are insured. Deposit insurance systems are largely established to protect the banking system against possible bank “runs” (unrestrained demand for cash by savers) that can cripple the financial intermediation process, disrupt the payments system, and have severe macroeconomic effects. These systems also protect small depositors from losses in the event of bank failures and give the nation a formal and consistent mechanism for resolving failing bank situations. Developing countries with deposit insurance include Colombia (since 1985), Kenya (1985), Nigeria (1989), and Yugoslavia (1985). Brazil and Bolivia are now in the process of establishing such a system. The recent burst of interest in deposit insurance by the developing countries parallels a similar surge in the developed world between the mid-1970s and mid-1980s. At present, almost all the major developed countries, including France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States have deposit insurance schemes.
Explicit versus implicit systems
Over the years, the governments of most developing countries that do not have deposit insurance systems have taken various policy actions to shield depositors of failing banks. These actions are frequently referred to as implicit protection of depositors, in contrast to the explicit protection offered by a formal deposit insurance system. Governments have tended to employ implicit protection most often in the case of the pending failure of public banks, as well as large private banks that may dominate a developing country’s banking system.
Explicit and implicit protection systems have essentially the same set of objectives—to maintain a stable banking system and protect small depositors in the event of actual bank failures. Moreover, both systems can employ the same set of mechanisms to resolve bank failures. These mechanisms include making cash payments to depositors of failed banks, transferring a failed bank’s deposits to another bank, arranging for the merger of a failing bank into another bank, or providing financial aid to an ailing bank to prevent its failure.
Pros and cons
In what ways is a deposit insurance system better than an implicit protection scheme? A well-functioning deposit insurance system is likely to produce faster, smoother, and more predictable resolutions of failing bank situations than an implicit system. This is largely because a deposit insurance system operates on the basis of predetermined “rules of the game,” whereas decisionmaking with an implicit system is always discretionary and ad hoc. Second, a deposit insurance system offers small depositors better protection because it is designed, in part, to accomplish this result. Third, a deposit insurance system provides a useful vehicle for shifting some of the costs of deposit protection to the banking system in the form of required premium payments. Imposing these costs on banks seems appropriate because deposit insurance benefits banks by lowering their cost of funds. With an implicit system, the banks derive benefits, but incur no direct costs. Instead, the costs are absorbed entirely by the national government budget (taxpayers) or the central bank. Finally, a deposit insurance system is likely to be somewhat more effective in stemming bank runs than an implicit system. The reason is that deposit insurance involves a legal obligation to protect depositors (up to a certain limit), whereas the level of protection under an implicit system is totally at the discretion of the government and, therefore, less assured.
There are, however, some drawbacks to a deposit insurance system. A major criticism is that, by explicitly covering deposits, it may encourage banks to take greater risks. This is a potentially serious problem and must be countered by effective government supervision of bank risk taking, especially the types of assets that banks acquire and the amount of capital that they hold. At present, some developing countries do not have effective bank supervision and examination systems in place to handle this problem. Deposit insurance also tends to be a more costly way to protect depositors than an implicit system, largely because the insurer is legally obligated to protect depositors up to the insurance limit, and typically has no discretion regarding the form or timing of payments made to depositors or to ailing banks in rescue operations. With an implicit system, the government has complete discretion, including the option of extending no protection at all in those cases where the stability of the banking system is not threatened.
Designing an insurance system
While the concept of deposit insurance is quite simple, deposit insurance systems are actually relatively complex mechanisms. Consequently, nations that decide to establish such systems will have to grapple with a sizable number of issues, some of which are not easy to resolve. Some major issues are discussed below.
Deposit insurance systems can be either public or private. Public systems are sponsored and administered by the government (sometimes with minority participation by banks in administering the system). Private systems typically are sponsored and solely administered by the banking industry. At present, most deposit insurance systems in both the developing and developed world are public systems. In establishing a public system, it is essential for the government to specify clearly the objective of the system. Is the sole objective of the system to protect small depositors in the event of bank failures? Or should the system have the additional aim of preventing contagious bank runs, an objective that occasionally may require the protection of large, as well as small, depositors?
Assuming that the deposit insurance system is going to be a public system, should membership by banks be voluntary or compulsory? There are strong reasons for compulsory membership, even though this represents greater government intrusion into the private sector of the economy. One reason is that voluntary systems are likely to produce periodic large-scale transfers of deposits within the banking system—from insured to uninsured banks during good times and from uninsured to insured banks when the banking system gets into trouble. Also, in a voluntary system, bank membership may be unstable, or the system may fail to attract sufficient membership to accomplish its objectives. Because of these potential problems, most developing and developed countries with public systems have made membership compulsory.
An important, basic feature of deposit insurance systems is the amount of protection extended to individual depositors. Almost all deposit insurance systems in the world place a limit on the amount of insurance coverage (with developed countries generally having higher ceilings). A limited coverage system has several desirable features: it gives full protection to small depositors, it gives the banking system at least some protection against contagious bank runs, and it preserves some degree of market discipline by exposing large depositors to potential losses. There are now only two systems, those in Yugoslavia and Norway, that offer 100 percent coverage. Unlike limited coverage systems, these two countries give the banking system a very high degree of protection against contagious runs, but also remove the onus of prudential management from banks, creating a “moral hazard” problem. The United Kingdom has employed the concept of coinsurance by insuring only 75 percent of each deposit balance up to a set maximum amount. With coinsurance, all depositors share the risk and, therefore, have an incentive to monitor the financial condition of individual banks.
The major problem with the widely used limited coverage is that it may not offer banking systems a large measure of protection against bank runs because they expose large depositors to potential losses. These depositors tend to be knowledgeable and are likely to precipitate a run when a bank is perceived to be in trouble. Given this prospect, some countries have authorized the deposit insurance corporation, when necessary, to resolve failing bank situations by extending de facto protection to uninsured depositors. The alternative to this arrangement is to allow the runs to occur and trust the ability of the central bank to handle them effectively by providing financial assistance. While this procedure may work well in some countries, it may not work well in others where the central bank is ineffective or where the runs take a form other than deposit transfers within the domestic banking system (e.g., capital flight).
The protection of large uninsured depositors can take the form of: (1) a purchase and assumption transaction, in which all of the deposits (insured and uninsured alike) of the failing bank are transferred to another bank; (2) a financially assisted merger of the failing bank with another bank; or (3) the provision of financial assistance to the failing bank to avert its failure.
Financial assistance can be provided in a variety of ways. Perhaps the simplest is for the insurer to make an equity capital injection into the failing bank. Alternatively, as was done in Chile, the insurer can purchase the nonperforming assets of a failing bank at par value, subject to the provision that the bank subsequently repurchase the assets at par value when the bank is restored to health. In the well-known Continental Illinois rescue in the United States, the insurer acquired nonperforming assets from the bank and, as compensation, received a controlling interest in the bank.
A final key element in the design of a deposit insurance system is its funding. This is important not only because it affects the ability of the insurance system to preserve confidence in the banking system, but also because it determines who will absorb the losses when banks fail. In most deposit insurance systems, much or all of the funding is provided by insured banks in the form of periodic premium payments into a deposit insurance fund. In some countries, however, the government shares the cost of deposit insurance. In India, Nigeria, and the Philippines, for example, the government made an initial capital contribution to the insurance fund in order to give the system credibility. In Spain, the government makes regular contributions to the fund in an amount equal to the aggregate contributions of the insured banks.
To function effectively, deposit insurance systems must be adequately financed. Unfortunately, the historical record indicates that many systems have been set up with woefully inadequate funding, given the losses that these systems often absorb, particularly in developing countries where banking systems are highly unstable.
Between 1984 and 1988, the deposit insurance system in the Philippines, for example, had to deal with the failure of approximately 140 small banks representing 6 percent of the total deposits of the banking system. Because the fund did not have sufficient resources, the insurer had to borrow to meet its obligations. In addition, the insurer raised bank premium assessments, which had the effect of reducing the profits of an already troubled banking system.
In establishing a deposit insurance system, a nation has to decide whether premium rates should vary depending on the overall riskiness of a bank. The major advantage of variable premium rates is that they create an incentive for banks not to take excessive risks. The major disadvantage is that the government must develop a system for measuring overall bank risk. Because the measurement of bank risk is very difficult, almost all nations have decided not to employ a variable premium rate system.
At present, about a dozen developing countries have deposit insurance systems, and it is likely that other countries will consider establishing such systems in the next few years. In assessing the need for such a system, a country must first decide whether it prefers an explicit deposit insurance system or an implicit deposit protection scheme, given the unique conditions existing in that country. As indicated earlier, both explicit and implicit systems have their advantages, and it is not clear that a deposit insurance system would be better in all countries. Then the country must ensure that the system has a reasonable chance of producing good results, that is, it is adequately funded and has some form of government support so that it will not founder and lose credibility during a period of difficulty. Finally, it is important to recognize that deposit insurance systems are no substitute for effective government supervision of banks. Supervision is essential to spot problems in bank management and in banks’ portfolios well before insolvency occurs and to compel banks to take corrective action.
International Monetary Fund announces
Government Financial Management
Edited by A. Premchand
This book, a collection of seminar papers and country studies, examines recent developments in government accounting and financial management in selected industrial and developing countries.
Available in English. ISBN 1-55775-149-8. x + 374 pp. 1990.
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