Deposit insurance has been viewed by some as having made a major contribution to “increasing confidence, encouraging savings, promoting the growth of financial institutions and increasing the flexibility of monetary policy,” 1 while Friedman and Schwartz have claimed that “federal insurance of bank deposits was the most important structural change in the banking system to result from the 1933 panic, and, indeed in our view, the structural change most conducive to monetary policy since … immediately after the Civil War.” 2 In view of such claims, the increased popularity of deposit insurance schemes within the past two decades is not surprising. However, there are costs as well as-benefits associated with deposit insurance. It is possible that alternative approaches may be as effective as formalized deposit insurance schemes, 3 particularly in many of the developing countries where local circumstances may render deposit insurance inappropriate, or at least less effective. Indeed, Friedman and Schwartz have also pointed out that “to avoid misunderstanding, we should note explicitly that deposit insurance is but one of several ways in which a panic-proof banking system could have been achieved. Our comments are not intended to suggest that some other method might not have been preferable to deposit insurance.” 4
This paper briefly discusses the historical background of and the rationale for deposit insurance. It then discusses the costs attached to deposit insurance and some of the technical questions involved in designing an optimal deposit insurance system (e.g., should deposit insurance cover all deposits or should its coverage be limited), as well as the interrelationship between deposit insurance and other regulatory approaches. 5
I. Historical Development of Deposit Insurance
The first formal system of deposit insurance, which was inspired by a Cantonese merchant’s mutual guarantee scheme, was established in 1829, in the State of New York, to guarantee both banknotes and deposits. Subsequently, a number of other states established similar schemes.
The experience of the state schemes was mixed. The panic of 1837 caused a number of them to cease insuring deposits, though not banknotes, although some of the schemes were voluntarily terminated after a long and successful life. 6 By the end of the 1800s, all of the deposit insurance schemes had withered away, but after the panic of 1907, eight states introduced such schemes.
In the changed circumstances of the twentieth century the experience of deposit insurance schemes was discouraging. Agricultural failures caused multiple insolvencies, and relatively high failure rates among larger banks 7 increased the burden still further. The vulnerability of any funded scheme that lacked lender-of-last-resort facilities became apparent.
By 1933 the private bankers had concluded that “these historical experiences show that the guaranty plan is inherently fallacious and based on erroneous premises and assumptions. It has proved to be one of those plausible, but deceptive, human plans that in actual application only serve to render worse the very evils they seek to cure.” 8 However, despite the bankers’ distrust of deposit insurance, there had been a great deal of political interest in such schemes. According to the Federal Deposit Insurance Corporation (FDIC), 150 bills were introduced in Congress between 1886 and 1930.9 Nonetheless, it was not until 1933 that a nationwide deposit insurance scheme was finally passed.
While the United States was the first country to introduce a statewide deposit insurance scheme, it was not the first country to introduce a nationwide system. In 1924, Czechoslovakia set up a sophisticated system of credit and deposit insurance. Two special funds were created: a Special Guarantee Fund was set up initially to help banks recover losses suffered because of the First World War, and a General Guarantee Fund was established with the express object of “encouraging savings by increasing the safety of deposits and ensuring the best possible development of banking.”10 Originally the two Funds were meant to be independently funded, but they incurred heavy losses and the Government had to intervene. The two schemes were administered, in practice, by the Ministry of Finance, although representatives of the banks were involved.
The Special Guarantee Fund served not only commercial banks (which in Czechoslovakia undertook universal banking) but also cooperative and savings banks. Contributions to the Fund were related to profits, and the Government also contributed. Banks that had experienced losses were able to draw on the Fund, and it was given wide powers to impose reorganization plans on the banks that required aid.
The General Guarantee Fund covered institutions that accepted savings or demand deposits. It was funded by contributions levied on the member institutions based on the interest paid on current accounts, savings deposits, and short-term debentures (at the rate of 3 per cent), as well as, in theory, by its income from investments. 11 Assistance was primarily meant for banks that were basically solvent. However, when a bank failed, the Fund paid up to 80 per cent of the general “worthy” creditors’ claims (with first priority granted to depositors). 12 “Worthiness” was to be determined by the administration of the Fund, with the proviso that creditors who had placed funds with banks at suspiciously high rates were not to be reimbursed (both Lebanon and the Federal Republic of Germany introduced similar provisions in their deposit insurance schemes).
Nine years after the inception of these schemes the Glass-Steagall Act established a temporary deposit insurance scheme in the United States, and in 1934 the FDIC was officially established. It is interesting to note that, while a majority of deposit insurance schemes subsequently established looked to the FDIC’s example (even, sometimes, where the name was concerned), the FDIC, as it was set up, and particularly following amendments to the original Act in 1935, was significantly different from the scheme envisaged in 1933. Moreover, the Czechoslovak example seems to have been echoed in the systems in at least some of the countries that subsequently introduced deposit and/or credit insurance schemes.
Following the establishment of the FDIC, and the Federal Savings and Loan Insurance Corporation, there was a prolonged hiatus before other countries followed suit. But after Turkey introduced its Bank Liquidation Fund in 1960, a number of countries set up deposit insurance systems, and several others are planning to do so.
Table 1 outlines the systems in the 13 countries that have introduced formal deposit and/or credit insurance schemes. As might be expected, they differ quite considerably from one another, reflecting both local circumstances and historic developments in the countries involved, and a brief outline of the similarities and divergences may be useful.
|Number of Institutions||Membership||Insurance Fund as Per Cent of Insured Deposits|
|Country||Name of Scheme||Date Scheme Set Up||Limits of Coverage||Financing of Scheme||Voluntary||Compulsory|
|Argentina||Deposit Insurance Scheme||1979||100% of deposits up to $a 100 million. 90% above that amount. Existing foreign currency deposits covered, new ones not.||Premiums and contributions from Central Bank (0.03% premiums from financial institutions)||461||X||To be determined|
|Canada||Canada Deposit Insurance Corporation (CDIC)||1967||Can$20,000 (foreign currency deposits not covered)||Assessments||100||X||0.2%|
|Quebec Deposit Insurance Board (QDIB)||1967||Can$20,000 (foreign currency deposits not covered)||Funded by provincial government||X||n.a. 1|
|Chile||…||1977 (interim scheme)||100 monthly tax units 2 (foreign currency deposits not covered)||Financed by Treasury||…||X||n.a. 1|
|Germany, Fed. Rep.||Deposit Security Fund (DSF)||1966||30% of net worth of each bank||Premiums of 0.3 per mill of deposits, special calls up to 0.6 per mill||255||X||…|
|Savings Bank Security Fund (SBSF)||1969||100% of deposits and credits||Premiums of 0.3 per mill of claims on customers until fund reaches 1.5 per mill, when premium will fall||611||X||0.15% (target)|
|Credit Cooperatives Security Scheme (CCSS)||1976 (amalgamation of 2 earlier schemes)||100% of deposits and credits||Complex premiums plus mutual guarantees||4,600||X||…|
|India||Deposit Insurance and Credit Guarantee Corporation (DICGC)||1962 (1978 merger of Deposits Insurance and Credit Guarantee schemes)||Rs 20,000 for deposits Rs 100,000 for credits (for partial guarantee)||Premiums of 0.4 per mill of deposits for deposit insurance, 0.25% of credits for credit insurance||1,440||X||0.46%|
|Japan||Deposit Insurance Corporation||1971||¥ 3 million (foreign deposits not covered)||Premiums of 0.06 per mill of insured deposits||1,120||X||0.035%|
|Lebanon||National Deposit Guarantee Company (NDGC)||1967||LL 30,000 (foreign currency deposits not covered)||Premiums between 0.5 per mill and 2 per mill have been levied||80||X||1.1%|
|Netherlands||Rabobank Insurance Scheme||…||100%||Collective guarantee system||…||X||n.a. 1|
|…||1979||f. 25,000 (to be indexed)||Ex post assessments||1,196||X||n.a. 1|
|Philippines||Philippine Deposit Insurance Corp. (PDIC)||1963||10,000||Premiums of ||920||X||Current assets equal 0.16% (of total deposits; actual Deposit Insurance funds equal only 0.002% of total deposits)|
|Turkey||Bank Liquidation Fund (BLF)||1960||100% coverage||Premiums of 0.5 per mill||38||X||0 (as of 1978 the BLF had just finished liquidating debts to the Central Bank)|
|United Kingdom||“Lifeboat” Deposit Protection Fund||1973|
|Effectively 100% ¾ of deposits up to maximum reimbursement of £10,000 (foreign deposits not covered)||Ad hoc assessment process Initial assessment of £5,000-300,000 (depending on the size of each bank), premiums of 0.3-0.6 per mill||…|
|United States||Federal Deposit Insurance Corporation (FDIC)||1934||$100,000 (foreign deposits not covered)||Premiums of ||14,750||X|
(Compulsory for nationally chartered banks and members of Federal Reserve System)
|1.15% (0.76% of total deposits)|
|Federal Savings and Loan Insurance Corporation (FSLIC)||1935||$100,000||Premiums (equal to about 0.6 per mill of total deposits)||4,070||X|
(Compulsory for federally chartered savings and loan associations)
|1.29% (of total savings)|
|National Credit Union Administration (NCUA)||1970||$100,000||Premiums of ||17,020||X (Compulsory for federally chartered credit unions)||…|
|Spain||Deposit Guarantee Fund||1977||Pta 750 million||50% from premiums of 1 per mill; 50% from Bank of Spain||108||X||0.13% (of demand & time deposits)|
A tax unit is a variable unit of account that has been increased pari passu with the rate of inflation.
A tax unit is a variable unit of account that has been increased pari passu with the rate of inflation.
Membership in a majority of the systems is compulsory. Only Argentina, the United States, and the Federal Republic of Germany permit banks to opt out of the system, and in the United States, the major banks are de facto required to be members, since both the Comptroller of the Currency and the Federal Reserve require their member banks to join the FDIC.
In a majority of the schemes there is a formal cutoff point for insurance coverage. However, most of these limits are implicitly indexed and two countries, the Netherlands and Argentina, explicitly index coverage; moreover, in a majority of them, the insurance limits are set so as to effectively cover virtually 100 per cent of deposits.
Seven of the 13 countries specify that representatives of private sector financial institutions should not be allowed to participate in the management of deposit insurance schemes, largely because it is felt that this would produce conflicts of interest. However, 4 other countries (the Federal Republic of Germany, Japan, Lebanon, and the United Kingdom) explicitly provide for private sector participation, and, indeed, in Germany the various schemes are de jure the sole responsibility of the private sector, although they are set up under government auspices.
The funding of the various schemes differs widely. Some countries have opted for an actuarially based approach under which reserves will be built up to a level sufficient to meet any expected calls on the system; others have opted for a policy of establishing only a relatively low level of premiums, and hence of the reserve fund, relying on special levies to meet any large calls on the system. One country—Turkey—has followed, in effect, a policy of ex post assessments.
From the foregoing it seems that, while the general desirability of deposit insurance has been recognized by all of the 13 countries, their assessments of what is technically appropriate or desirable differs considerably.
II. Rationale for Deposit Insurance
There are three main arguments in favor of deposit insurance: first, building or maintaining confidence in financial institutions and the financial system as a whole; second, deposit insurance may foster or permit more effective or efficient competition between financial institutions; and third, although it is somewhat outside the scope of an economic analysis, deposit insurance is, or is perceived to be, equitable.
The Chairman of the FDIC has stated that “the basic purpose of deposit insurance is to protect the banking system against destructive runs on deposits.” 13 In most countries, and particularly in developing ones, the banking system plays the central role in financial intermediation. At the same time, because of the basically short-term character of bank deposits and the fact that there are virtually no transaction costs involved in switching deposits between banks or in exchanging deposits for cash, it is peculiarly vulnerable to runs on banks that are perceived to be in difficulty. The major justification for deposit insurance from the viewpoint of the monetary authorities has, therefore, been that it engenders confidence in the financial system and hence reduces the external diseconomies resulting from frequent bank failures.
Historical experience, at least at first sight, suggests that deposit insurance is effective in stabilizing the financial system, for in most of the countries where it was introduced there was an immediate and sharp decrease in the frequency and severity of bank failures. For example, in the United States depositor losses equaled 2.15 per cent of insured deposits and 4,000 banks suspended payments to depositors in 1933. In contrast, from 1934 to the end of 1977 there were only 541 bank failures, and only 0.2 per cent of depositors with failed banks were not fully reimbursed. 14 However, deposit insurance alone should not take all the credit. Moreover, there are some a priori reasons for arguing that as long as less than 100 per cent of deposits are covered by insurance the potential for runs still exists.
Frequently deposit insurance was introduced as part of a package of such innovations as more flexible refinancing, closer and more effective regulation, and the encouragement of mergers or restrictions on new entry into the banking business. For example, if the Federal Reserve had been willing and able to provide emergency refinancing on a wider scale during the banking crisis of 1933, the number of failures might have been substantially reduced, even in the absence of deposit insurance. 15
In addition, it has been argued that if the monetary authorities run the economy efficiently there should be little risk of multiple insolvencies and runs on banks. As a corollary, some economists have suggested that the cost of depression-related insolvencies, as opposed to “normal” banking failures, should be borne by the monetary authorities rather than by the banks. 16 Argentina, Spain, and Lebanon are the only countries in which the state pays part of the explicit cost of deposit insurance.
The mere existence of deposit insurance does not, for a number of reasons, automatically remove the potential for runs on banks. Even if there is full coverage of one’s deposits there is an incentive to remove deposits from a failing bank because of the inconvenience associated with having deposits blocked and having to wait for repayment. Thus, even 100 per cent coverage reduces, but does not eliminate, the motivation for runs. More importantly, as long as deposits are not 100 per cent covered there is still every reason for depositors whose balances are not covered by insurance to remove their deposits at the first intimation of insolvency. The extent to which this is a threat to the stability of the banking system will depend on the distribution of deposits by size and the cutoff point for reimbursement. Perhaps because of this a number of countries have followed a policy of de facto coverage of 100 per cent of deposits, while nominally only covering depositors up to a fixed cutoff point.
An additional macroeconomic justification for deposit insurance in today’s world of increasingly integrated capital markets is to lessen the potential for capital flight ensuing from bank failures. For example, when Lebanon’s Intra Bank failed, there was a marked shift toward foreign banks, 17 which were perceived to be more secure as well as better able to call on their home country authorities and international capital markets in order to weather crises. In practice, the switched deposits largely stayed within Lebanon, but in similar circumstances the foreign banks might feel that they are loaned up domestically and look for external investment opportunities, with possible disruptive effects on the balance of payments.
While deposit insurance may help to prevent runs on banks, insolvent banks will still have to close. Some observers have argued that in a competitive financial system this is well and good, 18 but some countries have preferred to reduce the risk of insolvency by insuring credits. Most of the schemes have covered only a limited range of credits and have been intended more to channel funds toward socially desirable but high-risk credits. The Federal Republic of Germany is the only country where a scheme is explicitly designed to ensure the survival of credit institutions—in the schemes for the savings banks and cooperative societies.
If the arguments for deposit insurance in order to stabilize the financial system are weakened somewhat by the presence of strong central banks exercising effective bank supervision, the justification in terms of its contribution to competitive efficiency becomes more important. There are a number of different aspects of the question.
First, deposit insurance may facilitate increased competition between banks, because if bank failure is made less painful to depositors and the economy then the monetary authorities can adopt a more liberal attitude toward bank regulation and licensing of new institutions. 19 New entrants can more readily be admitted to challenge existing banks, and banks can be allowed to assume greater risks in their lending. 20
Second, deposit insurance may contribute to competitive equality between different banks. For example, in the absence of deposit insurance, large banks might be viewed as inherently safer than smaller ones; nationalized banks might be regarded as implicitly guaranteed by the state; and foreign-owned banks might be seen as more secure than domestic ones. With deposit insurance, these competitive advantages will be eroded somewhat, although as long as there is less than 100 per cent coverage of deposits they will not be eliminated. 21
The arguments in favor of freedom of entry are more compelling in larger economies with well-developed financial systems. In small, less developed financial systems, the banks may still be reaping economies of scale that more than compensate for the welfare costs imposed by a lack of innovation and competition. 22
While the arguments for deposit insurance in order to enhance competition may well be persuasive, increased competition may have drawbacks. Tussing, for example, admits that it is necessary to ensure that failures of unsound banks do not, in turn, precipitate collapses of sound banks and that the external consequences of bank failures for employees, creditors, and customers be minimal before a policy of allowing “meaningful bank failure” can be advocated. 23 Moreover, while deposit insurance may improve competitive efficiency in the banking system, it may have adverse consequences for other financial institutions and markets, particularly if the cost of the guarantee does not reflect a market cost but is indirectly subsidized by, for example, the monetary authorities standing ready to act as lender of last resort to the deposit insurance scheme. If the macroeconomic arguments for insuring deposits are less than overwhelming, one might ask why banks should be given a further advantage vis-à-vis security markets and nonbank financial institutions.
While the original motivation for deposit insurance seems to have been worry about the macroeconomic consequences of a laissez-faire approach, the political aspects cannot be ignored. Protecting small savers has been a popular cause, and one can argue that the small saver deserves aid because he is unable or unlikely to have access to sufficient information to permit him to evaluate the solvency of those banks in which his savings are held. It is largely because of such considerations that some deposit insurance schemes have had relatively low cutoff points, since it was argued that caveat emptor should continue to apply for larger depositors.
Considerations of equity are largely outside the scope of an economic analysis, but it might be pointed out that limiting the insurance coverage to a maximum amount per deposit may impose considerable hardship on some depositors and that, theoretically at least, a program of welfare payments can always be pareto optimal, since the payments can be made to the most needy rather than assuming that the small depositors are necessarily the more needy.
III. Costs of Deposit Insurance
Deposit insurance is not costless, and while the costs, relative to the deposits insured, may be very small, they are not negligible and must be weighed against the benefits.
There are three major types of costs associated with a deposit insurance scheme: the direct costs—including operating costs and payments, the opportunity cost, and other indirect costs, in particular the costs attributable to regulatory rigidities.
The direct operating costs are not necessarily inconsiderable. The FDIC, for example, employs 3,700 people and has an operating budget of $89 million a year. While this is only 0.0129 per cent of insured deposits, it imposes a not unnoticeable cost on banks, given the low-margin nature of their business. It should be noted, however, that other systems operate with far fewer employees and far lower costs. The Turkish scheme, for example, has no full-time employees, while the Lebanese scheme has about six full-time employees and the Japanese one has about a dozen. Moreover, the large number employed by the FDIC can be seen as the result of its supervisory duties, since 70 per cent of the employees are involved in bank supervision.
In theory, the operating costs of a deposit insurance scheme resulting from payments can be defined as the present value of expected payments over the life of the scheme, and Merton has derived an equation that gives the total cost of deposit insurance as a function of the ratio of deposits to assets and the variance of the logarithmic change in the value of the assets during the term of the deposits. 24 Relating this to practice, Merton’s approach suggests that the “cost” of deposit insurance (but only the cost of payments) is effectively related to the capital adequacy of the banking system as a whole 25 and the volatility of asset values. However, practical experience suggests that this valuation suffers from a number of shortcomings. In particular, an empirical study by Orgler of recoveries from failed banks (and hence of net payouts) did not reveal any significant relation between capital and recoveries in the United States, and fluctuations in asset value were not effective predictors of bank failures. 26
An alternative approach is simply to look at the historical experience of deposit insurance schemes. The available, albeit incomplete, data on the payment experience of the various schemes suggests that with the possible exception of the Philippines and the United Kingdom payments have been relatively insignificant.
Premiums are not included in direct operating costs. Although from the point of view of individual banks they are a direct cost, and a not inconsiderable one, with premiums of as high as 2 per mill (in Lebanon), from the viewpoint of the economy as a whole, they constitute a transfer of funds from the banks to the deposit insurance fund, with a possible opportunity cost or benefit.
From the viewpoint of the banks, the opportunity cost of a deposit insurance scheme equals the average rate of return on the investment of funds by the banks times the level of the fund. However, from the point of view of society, the opportunity cost of a deposit insurance fund will be less than that, as long as there is some positive rate of return on the investments of the fund, even if the receipts do not accrue to the banks; the social opportunity cost for a funded system will equal the difference between the social rate of return on the investment of resources by the banks and that on the deposit insurance fund times the level of the fund.
Different countries have revealed very different assessments of what constitutes an appropriate level of deposit insurance funds. At one extreme, Turkey has no fund, since the system of assessments has been effectively ex post; at the other extreme, Lebanon has built up a fund equal to over 1 per cent of total deposits (as opposed to total insured deposits).
The major indirect cost that may be associated with deposit insurance is the introduction of regulatory rigidities. As pointed out earlier, deposit insurance theoretically offers an opportunity to relax regulatory controls. On the other hand, historical experience suggests that the introduction of deposit insurance has typically been accompanied by an increase in regulation, and it has been argued that “deposit safety is not a free good, but is purchased at a substantial cost, including the introduction or maintenance of regulatory rigidity for the banking and savings and loan businesses.” 27
While the final decision as to whether or not deposit insurance is appropriate for a given country and if so which system should be implemented must necessarily rest with the authorities’ assessment of the relative balance of costs and benefits, some of the factors which could militate for and against deposit insurance may be pointed out.
First, the probability of bank failures, and hence the justification for deposit insurance, will be greater, ceteris paribus, the larger the number of banks (most schemes have been introduced in countries with hundreds and even thousands of banks), the more volatile the economy, and the more laissez-faire the authorities’ approach. Conversely, a country with limited entry of new banks, a static economy, and close prudential regulation of banking activities will normally have fewer failures.
Second, if there is a substantial number of foreign banks and/ or a number of large banks dominate the system, the authorities may wish to introduce deposit insurance to redress the competitive imbalance.
Third, while it is unlikely to be the case for the larger and more well-developed financial systems, the need for deposit insurance, and a visible and independent insurance fund, will be greater if the public lacks confidence in the monetary authorities’ ability or willingness to rescue failing banks. For example, if deposits denominated in foreign currency are large, the ability of the authorities to provide foreign currency could be limited. Alternatively, if the central bank’s law does not provide sufficient flexibility, ad hoc rescue schemes might not be possible even though the necessity for a formal deposit insurance scheme was otherwise limited.
IV. Some Technical Aspects of Deposit Insurance
Even if a country decides that there is a need for deposit insurance, it will still need to decide on which system to implement and which operational strategies to follow. The most commonly raised questions are the appropriate administration and financing of the scheme; the desired coverage of deposits, including the decision as to which institutions will be covered; and the interrelation between banking regulation (including capital adequacy requirements) and deposit insurance.
At first sight there seems little reason why a deposit insurance scheme should not be organized and administered solely by the insured institutions. However, while a system organized and administered by the banks might be satisfactory from their point of view, there are some grounds for doubting whether it would be satisfactory from the point of view of society as a whole. The problems are analogous to those of capital adequacy regulation. Banks have no incentive to agree to premium payments greater than their marginal private return, but society’s welfare maximization may well imply a greater marginal social return on deposit insurance. Resolution of this dichotomy may, therefore, require state participation in the scheme. Moreover, on a practical level, any deposit insurance scheme run by and for the banks is likely to lead to conflict of interest for the administrators of the scheme, particularly in concentrated banking systems. In practice, most of the deposit insurance schemes presently in existence have been organized, and to some extent imposed, by the monetary authorities, and in some schemes participation in the administration of the scheme is expressly forbidden to private bankers.
The question of the independence of the deposit insurance scheme from the central bank, or Ministry of Finance, can also create problems. In countries with a tradition of “checks and balances” there may be a tendency to set up a separate, legally independent deposit insurance corporation. However, such a move can involve undesirable duplication of facilities, particularly in the supervision and regulation of banks.
In general, the smaller the country the greater the relative burden of another layer of bureaucracy, and the less the probable workload of the scheme the more compelling will be the argument for incorporating the deposit insurance scheme, at least for practical purposes, within the central bank.
A deposit insurance scheme can be financed in a number of ways. One way is to set up a fund out of which claims can be met; another is to take an ex post approach, with special assessments being levied after bank failures to reimburse depositors. An allied question is whether or not the monetary authorities should finance the scheme, at least partially, or whether it should be financed wholly by the insured institutions.
The major justification for an independent fund is that it ensures confidence in the scheme. However, there has been criticism of reliance on a previously accumulated fund, since it imposes a burden on the banks even if no calls are made on the fund. 28 Moreover, a permanent fund may be ineffective, since with rapid inflation and/or a rapid growth of the banking system the growth of potential liabilities may outstrip the accumulation of the fund, particularly when, as has often been the case, the deposit insurance fund is invested in financial assets with negative real rates of return.
Even if an insurance fund is established, historical experience suggests that the monetary authorities will still need to stand ready to act as lenders of last resort in case of system-wide calls on it because of multiple insolvencies.
If the government and the central bank are the ultimate guarantors of the scheme, one can argue that it may make more sense to dispense with a fully funded scheme and instead simplify matters (and reduce administrative expenses) by letting the central bank, or the Treasury, pay off depositors in failing banks and subsequently assess the remaining banks. De facto, this is what Turkey has done, since the bank failures antedated the foundation of the Bank Liquidation Fund. The disadvantage of this approach is that the banks which fail will, by definition, not contribute toward the cost of the scheme. However, if failures are likely to be few, this need not be a major disadvantage.
In general, it is likely to be very difficult if not impossible actuarially to establish an appropriate level for a deposit insurance fund. For example, Table 1 shows the wide variation in funds which different countries have established in practice. Moreover, from a theoretical viewpoint there are problems in estimating the probability of future calls on the insurance scheme. First, in many countries the historical experience of bank failure is so limited that little reliance can be placed on it for estimation purposes. Second, the introduction of deposit insurance changes the parameters markedly, since, on the one hand, it decreases the probability of bank failure due to runs on banks, while, on the other hand, it may allow the regulatory authorities to adopt a more sanguine attitude to risk taking and hence to occasional bank failure.
The major argument in favor of the authorities bearing part of the cost of a deposit insurance scheme is that the authorities may have contributed to some of the failures through their policy measures. Moreover, they also benefit from the scheme’s existence, since it contributes to financial stability. Despite such arguments, most countries have preferred to finance the schemes solely by premiums levied on the insured institutions.
Premiums that are not fixed but instead vary according to the riskiness of a bank’s business have been advocated and discussed with increasing frequency. 29 It has been argued that it is economically more efficient to allow the banks to decide on their optimal allocation of assets, with regulators simply establishing premiums related to the risk of failure of each bank based on the riskiness of the banks’ portfolios, their liquidity positions, and their capital adequacy. But so far no country has considered them practical, although the then Chairman of the FDIC did show some responsiveness to the idea in 1976. 30 The Federal Republic of Germany is the only country that has different premiums for different insured institutions, 31 although the relationship between the premiums cannot be varied. However, Argentina, in its new scheme, provides for premiums to be varied “on the basis of objective tests.”
There are three main questions regarding coverage under deposit insurance: first, should the scheme be voluntary or compulsory, and which institutions should it cover; second, should deposits be fully covered; and third, how should deposits denominated in foreign currency be treated.
Voluntary versus compulsory participation
In most of the countries that have introduced deposit insurance—with the important exceptions of Argentina, the Federal Republic of Germany, and the United States 32—membership has been compulsory. Even the Philippines, which originally emulated the FDIC by making membership voluntary, decided to make deposit insurance compulsory following the failure of several large uninsured banks.
The main argument for compulsory insurance is that otherwise some banks (for example branches of reputable foreign banks and large banks, or small banks with a quasi-monopoly because of their geographic location) may gain a competitive advantage, since they may be able to opt out of the system and avoid the cost of the premiums without markedly affecting depositors’ willingness to place funds with them. If the larger banks opt out, the cost of the scheme to the other banks may become prohibitive without the cross subsidization provided by levies on the larger and more secure banks.
Another question is which institutions should be covered. If the protection of demand deposits in order to prevent disruption of the money supply is the major objective, one might argue for membership of commercial banks only. However, in many countries the protection of deposits in “near banks” has been an important objective. For example, the economic consequences of multiple collapses of building societies in the United Kingdom or savings and loan associations in the United States might be as disruptive as failures of commercial banks. Moreover, if deposit insurance does not extend to nonbank financial intermediaries, then the banks may be placed at a considerable competitive advantage, as mentioned earlier.
Nonresident and foreign currency deposits
Several deposit insurance schemes explicitly refuse to insure deposits denominated in foreign currency and/or nonresidents’ deposits (see Table 1). The exclusion of any one category of deposits, however, is open to the criticism that the risk of a run precipitated by uninsured, or partially insured, depositors is still present.
Full or partial coverage
Most countries have opted for less than full coverage of deposits because of considerations of equity (the small depositor needs protection, the larger does not), the need to retain the “discipline” imposed by large depositors, or the desire to reduce potential claims on the deposit insurance scheme. Increasingly, though, this approach has come under fire. 33
The argument that small depositors need protection more than larger depositors is open to question, as is the assumption that a cutoff or partial coverage is the best way to do this. Moreover, by limiting coverage, the schemes may favor the larger banks, which are often viewed as “safer” for large depositors because it is believed that the monetary authorities will be less willing to allow them to fail. 34 If only a part of deposits are covered, the incentive to switch deposits out of failing banks and the potential for runs remains. This would vitiate the major macroeconomic justification for deposit insurance. Perhaps reflecting these considerations, the limits in the Federal Republic of Germany have been set at a level that effectively guarantees 100 per cent coverage, while in the United States the FDIC has used its powers to rescue banks with a “purchase and assumption,” 35 which de facto insures 100 per cent of deposits. 36 Moreover, it has been calculated that the additional cost of 100 per cent insurance, at least in the United States, would be minimal.37
The second claim is somewhat more sustainable, but even here it is doubtful whether large depositors can or should provide “discipline” by withdrawing their deposits from large banks. They are likely to lack sufficient information to distinguish between solvent and insolvent banks, and it is arguable that the task should be left to the regulators. In addition, if large depositors are not covered they may well precipitate speculative runs on otherwise solvent banks.
The last argument, namely, the desire to reduce potential claims on the system, is the least compelling. It might be a consideration for a system designed by and for the commercial banks but it certainly should not be the dominant one for the monetary authorities.
Deposit insurance, it is argued, increases the burden of regulating and supervising the banking system, since it may allow banks to substitute deposit insurance for capital; it may remove the discipline imposed by depositors; and it may require the monetary authorities to assume more responsibility for rescuing or liquidating failing banks.
Since depositors will be less concerned about capital adequacy, banks may be able to attract deposits with lower levels of capital once deposits are insured than would otherwise be the case; some empirical studies have found evidence suggesting that this may have taken place. 38
On a priori grounds one might question whether there will be a significant substitution of deposit insurance for capital. First, both owners and managers of banks are often likely to be risk averters. In particular, where management is divorced from ownership, and “satisficing” rather than profit maximizing is the rule, the management’s reward for assuming higher risks is unlikely to be commensurate with the potential costs (namely, the virtual loss of a banker’s career when a bank is liquidated). Second, even if banks do wish to increase their leverage following the introduction of deposit insurance, the regulators may well be able to prevent them from doing so.
Other regulatory duties need not necessarily increase markedly as a consequence of deposit insurance. In most countries the regulatory authorities are already administering the apparatus of prudential supervision and in many cases they are already involved in rescuing or liquidating banks. Therefore, while the introduction of deposit insurance may increase their work marginally, it will not change it qualitatively; indeed, as pointed out earlier, it might even lessen the regulatory burden somewhat.
Mr. McCarthy, an economist in the African Department, was an economist in the Central Banking Department when this paper was written. He is a graduate of the London School of Economics.
J. A. Marlin, “Bank Deposit Insurance—I: Its Development in the USA,” Bankers Magazine (London, September 1969), p. 117.
Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960, National Bureau of Economic Research (Princeton University Press, 1963), p. 434.
For example, either credit insurance or more stringent regulations (including, perhaps, increased capital requirements) could theoretically serve as substitutes for deposit insurance.
Friedman and Schwartz (cited in n. 2), p. 442, n. 18.
Argentina, Canada, Chile, the Federal Republic of Germany, India, Japan, Lebanon, the Netherlands, the Philippines, Turkey, the United Kingdom, and the United States have introduced deposit insurance schemes: Marlin (cited in n. 1), p. 116. The Netherlands is about to establish a broader scheme than the present one (which covers only the cooperative banks), and the United Kingdom has replaced an ad hoc rescue operation (the “lifeboat”) with a formal insurance scheme. This study draws upon a more detailed survey, copies of which may be obtained from the author, whose address is International Monetary Fund, African Department, Washington, D. C. 20431.
For example, Indiana’s scheme operated successfully from 1834 to 1865, until the taxation of circulating notes of banks caused its closure: Federal Deposit Insurance Corporation, “History of Legislation for the Guaranty of Bank Deposits,” Annual Report, 1950, Part III, p. 64.
Ibid., p. 65.
American Bankers Association, Economic Policy Commission, The Guaranty of Bank Deposits (New York, 1933), p. 42.
Federal Deposit Insurance Corporation (cited in n. 6), p. 68.
Quoted by L. J. H. Dark in A. M. Allen, S. R. Cope, L. J. H. Dark, and H. J. Witheridge, Commercial Banking Legislation and Control (London, 1938), p. 137.
In practice, the contributions tended to be ex post rather than ex ante and were paid directly to depositors.
The original plan for the FDIC also included a scheme for partial reimbursement of all deposits, as opposed to the final scheme which provided full reimbursement of part of deposits.
Robert E. Barnett, “FDIC: Six Alternatives to the Present Deposit Insurance System,” address before the Nebraska Correspondent Bank Conference, Lincoln, Nebraska, September 24, 1976, FDIC News Release PR-82-76 (September 24, 1976), p. 1.
Federal Deposit Insurance Corporation, Annual Report (various issues).
Many of the failing banks were not eligible for refinancing because they were not members of the Federal Reserve System.
W. E. Gibson, “Deposit Insurance in the United States: Evaluation and Reform,” Journal of Financial and Quantitative Analysis, Vol. 7 (March 1972), pp. 1575-94; Kenneth E. Scott and Thomas Mayer, “Risk and Regulation in Banking: Some Proposals for Federal Deposit Insurance Reform,” Stanford Law Review, Vol. 23 (May 1971), pp. 857-902.
Talal Georges, Le Système Monétaire et la banque au Liban (Beirut, 1970), pp. 171-85; Harold S. Taylor, “The Day They Shorted the Intra Bank,” Bankers Magazine, Vol. 150 (Boston, Winter 1969), pp. 9-18.
A. Dale Tussing, “The Case for Bank Failure,” Journal of Law and Economics, Vol. 10 (October 1967), pp. 129-48, and “Meaningful Bank Failure: A Proposal,” Journal of Industrial Economics, Vol. 18 (July 1970), pp. 243-55.
A. Dale Tussing has made the strongest arguments for this approach: ibid.
U.S. Representative Wright Patman, then Chairman of the House Banking Committee, was quoted as saying that when we boast of no bank failures, let’s remember that several thousand other business firms may have failed because the banks did not take as many reasonable risks as they might have taken.”—George J. Benston, “Bank Examination,” The Bulletin, Nos. 89-90, New York University, Graduate School of Business Administration, Institute of Finance (May 1973), p. 63.
The Chairman of the FDIC was quoted as saying that “one-hundred percent deposit insurance would probably improve the competitive positions of small vs. large banks and of new vs. established institutions.”—Barnett (cited in n. 13), p. 6.
Abstracting as well from the perennial second-best problem.
Tussing, 1970 (cited in n. 18), p. 245.
Robert C. Merton, “An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees: An Application of Modern Option Pricing Theory,” Journal of Banking and Finance, Vol. 1 (June 1977), pp. 185-206.
Since the ratio of deposits to total assets is effectively equivalent to 1 minus the ratio between capital and reserves and total assets.
Y. E. Orgler, “Capital Adequacy and Recoveries from Failed Banks,” Journal of Finance, Vol. 30 (December 1975), pp. 1366-75.
Scott and Mayer (cited in n. 16), p. 858.
Scott and Mayer (cited in n. 16), p. 858.
Jack Revell, “Reforming UK Bank Supervision,” The Banker, Vol. 126 (September 1976), pp. 1021-24; Thomas Mayer, “A Graduated Deposit Insurance Plan,” Review of Economics and Statistics, Vol. 47 (February 1965), pp. 114-16; Scott and Mayer (cited in n. 16); Robert Taggart, Jr., “Regulatory Influences on Bank Capital,” New England Economic Review, Federal Reserve Bank of Boston (September/October 1977), pp. 37-46.
Barnett (cited in n. 13), pp. 16-18.
In the Credit Cooperatives Security Scheme.
Although membership is theoretically voluntary in the United States, nationally chartered banks and members of the Federal Reserve System are required to join.
Revell (cited in n. 29); David Burras Humphrey, “100% Deposit Insurance: What Would It Cost?” Journal of Bank Research, Vol. 7 (Autumn 1976), pp. 192-98; Gary Leff, “Should Federal Deposit Insurance be 100 Percent?” Bankers Magazine, Vol. 159 (Boston, Summer 1976), pp. 23-30.
Thomas Mayer, “Should Large Banks be Allowed to Fail?” Journal of Financial and Quantitative Analysis, Papers and Proceedings, Vol. 10 (November 1975), pp. 603-10; Barnett (cited in n. 13).
A procedure whereby the FDIC assumes the bad debts of a failing bank and sells the remainder of the operation as a going concern to another bank.
Barnett (cited in n. 13), p. 2.
Humphrey (cited in n. 33).
Sam Peltzman, “Capital Investment in Commercial Banking and Its Relationship to Portfolio Regulation.” Journal of Political Economy, Vol. 78 (January-February 1970), pp. 1-26; J. J. Mingo, “Regulatory Influence on Bank Capital Investment,” Journal of Finance, Vol. 30 (September 1975), pp. 1111–21. Peltzman finds a clear substitution, while Mingo’s results are ambiguous. However, to the extent that deposit insurance decreases the risk of failure resulting from runs on otherwise solvent banks, it can be argued that a decrease in capital (and liquidity) ratios concurrent with the introduction of deposit insurance represents a rational response to decreased risk rather than a substitution.