Garcia: A deposit insurance system guarantees that small depositors will receive their funds if their banks fail. In a broader sense, however, a deposit insurance scheme also provides a crucial set of incentives for the financial system. If those incentives are right, wealthy depositors will discipline their banks, bankers will not gamble with others’ money, borrowers will repay their loans, and politicians will resist interfering with sound regulation. If all this happens, you have better banks, faster economic growth, and greater financial stability. Of course, a deposit insurance system can also provide the wrong incentives and actually make things worse.
Garcia: Different countries have different objectives, but the two most popular aims are to help stabilize the financial system and to protect the small, unsophisticated depositor. It’s important to protect small depositors because you don’t want them to get scared, line up outside banks, and be seen on television. That generates a panic among other depositors and politicians, who in turn do some bad and unnecessary things.
Small depositors really don’t have the resources to monitor banks; monitoring is a complex and time-consuming task in a modern economy with derivatives and international transactions. Monitoring should be left to the large depositors—the people with the resources.
Garcia: First of all, be realistic. Deposit insurance is no panacea. If you have a weak banking system, improve it before you put your deposit system in place. When you put the scheme in place is also important. Then, you want your system to be compulsory, explicit, and transparent. Once all of that is done, there will be room to fit the design to country circumstances.
The system should be compulsory because if weak banks fail and lose money, deposit insurance premiums will rise, and stronger banks will drop out. Gradually, the system will deteriorate. One country had exactly this experience. It started off with 140 members in its deposit insurance scheme and is now down to 6.
The deposit insurance scheme should also be written into the law. You want the public to know, clearly, what is covered and what is not. Otherwise, they can’t protect their interests. And you want to publicize all of this. Your deposit insurance agency should have a logo and should do some advertising. It may, perhaps, publish a pamphlet that explains to the public just what the rules are.
Garcia: It’s crucial. If the public doesn’t know about the deposit insurance scheme, or doesn’t trust it, it’s pretty useless. Part of that confidence, of course, depends upon the system’s funding. The public must believe the system is well funded; it must have confidence that the money will be there when needed.
Garcia: Some countries, such as the United States, build a fund. That fund, collected from banks and thrifts, totals about $40 billion right now. Canada has a fund, but a small one. If one of its banks failed, Canada would borrow funds if more money were needed. Other countries, such as the United Kingdom, essentially don’t have a fund. If a bank fails, the authorities say, "OK, surviving banks, chip in some money to pay the depositors."
The differences partly reflect the relative power of banks in these countries. A concentrated banking system with powerful bankers may want to be in charge of its deposit insurance scheme. Privately run schemes historically have had ex post funding. Very often, government-run schemes accumulate a lot of money, in part to protect the government. Without a pot of money on hand, depositors might well expect taxpayers to reimburse them.
Garcia: An overindulgent system creates moral hazard. If virtually everyone’s entire deposits are covered, then no one keeps an eye on the condition of banks. You want to protect small depositors, but you want those in the private sector who are able to be vigilant to remain so. If large depositors see a bank taking on too risky a portfolio, they will move their money. That’s a powerful means of disciplining the bank. You don’t want to rely entirely on government regulation to make sure the banking system is sound. The private markets have a role—they have different sources of information and know different things from the regulators.
We touched earlier on the problem of stronger banks opting out of voluntary systems. Another concern is that in a system without adequate funding, regulators or supervisors may be tempted to keep a bank open longer than it should be. That gives the people in charge of the bank an opportunity to gamble for recovery. And as the U.S. saving and loan crisis showed, these gambles usually lose. The system simply becomes more insolvent—something we’ve seen in a number of countries around the world.
There is also the potential for tension between regulatory agencies that have somewhat different objectives. In a government-run system, the government deposit insurance system is an agent for both the depositors and the taxpayers. A proper balance has to be struck. There may be interagency conflicts—the lender of last resort may have a different agenda from that of the deposit insurance agency, and the minister of finance may have yet a third one. These different agencies must talk and not regard each other as enemies but as complementary parts of an overall safety net. But that’s surprisingly difficult to do.
Garcia: The IMF never goes into a country and says, “You don’t have a system of deposit insurance. You need one.” Rather, if a country comes to the IMF and says, “We’ve decided to create a deposit insurance system; how do we do it best?” the IMF staff will advise that the system should be compulsory, explicit, well funded, and transparent, which means the public and the supervisors must have good information.
And then the staff will consider country conditions—whether a deposit insurance system would be better funded ex post, whether it should be a private or a public system, and so on. The nature of the banking system also plays a part in this advice.
Garcia: Branches of foreign banks that take retail deposits are required to join the deposit insurance system. If they don’t take retail deposits, they probably won’t be allowed to join. Branches of domestic banks operating abroad are typically not part of a deposit insurance system. They would have to join the system in the host country. Virtually the only exceptions to this general rule are the countries of the European Union, which allow branches of foreign banks to be covered.
Garcia: During the Asian crisis, a number of countries put on comprehensive guarantees. They believed the situation could escalate into the equivalent of the Great Depression, and they wanted to avoid that. A full guarantee is a last resort.
Indonesia, Japan, Korea, Malaysia, and Thailand all put on full guarantees; Hong Kong SAR, India, the Philippines, and Singapore did not. Elsewhere, Mexico put on full guarantees during its crisis; Argentina did not. Finland and Sweden did so in the early 1990s; Norway did not. Which crisis was worse than the other? It’s a judgment call. Countries have to weigh the pluses and the minuses and figure out whether they can withstand both local and international pressures. If a country has good resources and is particularly worried about the severity of a crisis, it will probably opt for guarantees.
If a country decides to issue a full guarantee of deposits, it should be explicit, credibly funded—which means the government has to do so; bankers can not—and temporary to avoid the long-term moral hazard problem that arises if everyone is covered. In terms of timing, if you extend full guarantees before the public perceives there really is a crisis, you likely lose the opportunity to do it well and you exacerbate moral hazard. Countries should impose full guarantees only when they absolutely have to. Even so, the question of when you put on a full guarantee is less thorny than the question of when you take it off.
A number of Asian countries are now in the process of removing full guarantees. Mexico has said its full guarantee will be gone by 2004—it is phasing it out. Korea took one small step and plans to remove the remainder of the full guarantee by the end of the year. Japan announced when it put on the full guarantee that it would remove it in April 2001, but it has since postponed that to 2002. Premature removal risks a resurgence of payments problems, borrowers being unable to borrow, depositors running, foreign creditors pulling out their money, and panic. But the greater danger is leaving the full guarantee on too long.
There are no easy answers in terms of the right time to remove full guarantees. Basically, as an academic advised, “You take it off when it’s not an issue anymore.” You have to give the public plenty of notice—a couple of years. It’s useful to set a deadline, even if you then have to move it back, as Japan has done. Everyone is on notice that the full guarantee is an emergency measure and will disappear. As to whether it is better to remove a full guarantee in one step or in phases, we don’t know enough to say. Finland and Sweden took it off in one go. The two countries that are now phasing it out are the exceptions.
Garcia: Whether to have a fund or not, and if you have a fund, whether to have a large or a small one. One area that clearly needs substantial improvement is the speed with which the system pays depositors. Small depositors need their money pretty fast to pay for groceries and so on, but countries typically take months to pay. The U.S. Federal Deposit Insurance Corporation deals with the problem over the weekend, but that is very, very unusual. Most countries take much longer. They are looking for ways to accelerate payment, but a lot of legal systems make it very difficult to do that. They require the depositor to lodge a claim and show proof. ATMs may offer one means of providing quick payment, but you still have the problem of verifying the claim. Some countries rely on the bank’s records and just feed this information into their deposit insurance program. But multiple accounts must be aggregated under the one depositor identity number. The bank’s own recording information has to be very good—something that is costly for the banking industry. One of the challenges is for banks to modernize their systems sufficiently to make fast payments.
Garcia: Bank supervision and regulation are very important for the health of the financial system, as are a judicious lender of last resort, the integrity of the government, the quality of the legal system, and the role of the press in monitoring bank performance. Deposit insurance is just one piece of the network that keeps a financial system prosperous and stable. But there is a degree of excitement among deposit insurance aficionados right now. Last fall, the Financial Stability Forum created a Working Group on Deposit Insurance. Deposit insurers are finally able to get together, as central bankers and bank supervisors have long been able to do. Now there seems to be more interest in, and a greater appreciation of, the role deposit insurance can play in the financial system safety net. If domestic safety nets are done well, international financial stability is strengthened.
Copies of IMF Working Paper No. 00/57, Deposit Insurance and Crisis Management, by Gillian Garcia, are available for $10.00 each from IMF Publication Services. See page 239 for ordering information.
Ian S. McDonald
Senior Editorial Assistant
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