Banking Soundness and Monetary Policy
Chapter

21 Depositor Protection and Banking Soundness

Editor(s):
Charles Enoch, and J. Green
Published Date:
September 1997
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Author(s)
GILLIAN GARCIA

In most countries, banks are the most important financial institutions for intermediating between savers and borrowers, executing monetary policy, and providing payment services. At the same time, the configuration of their portfolios makes them especially vulnerable to illiquidity and insolvency. In particular, they are highly leveraged and maintain liquid assets that are intended principally to be sufficient to meet withdrawals in normal times.

Banks’ liabilities are composed of short-term, par-valued instruments that often can be called on demand. Moreover, their loans tend to be longer-term and, although they also are par-valued, they are opaque and so have little or no secondary market; moreover, loans are not always repaid. Banks also make investments, for example, in government securities, but these can also carry credit risk. While such very short-term instruments provide liquidity, the prices of longer-term securities can be highly volatile. Thus, banks are subject, in particular, to credit, market, and interest rate risks that explain their exposure to illiquidity and insolvency. Because of their sequential-servicing (first-come-first-served) practices, bank customers are likely to run if they doubt their bank’s ability to repay on demand.

There is concern that the demise of one bank, if handled poorly, can spill over to others creating negative externalities and causing a more general problem. For these reasons, many governments consider interceding in the functioning of the free markets to provide a safety net for banks that includes a lender of last resort and a system of deposit protection in addition to a system of bank regulation and supervision.

The objective of this intervention is primarily to promote financial stability and to develop a banking sector that is capable of financing economic growth on a sustainable basis. However, both the lender of last resort and the system of deposit protection have other goals that are particular to them. While each can be beneficial if well configured, they are not without drawbacks. In particular, if poorly designed, they can disrupt the economy’s incentive structure and so weaken, rather than strengthen, the banking system in the longer term. This paper examines best practices for the deposit protection and violations of them.

The System of Deposit Protection

Countries often have several objectives when they establish a system of deposit insurance. Some of these objectives are achievable; others are not. One of the most common, but regrettably unrealistic, goals is to avoid a potential crisis or resolve an existing one. The incompatibility arises because doing so will, most probably, require a full guarantee, which conflicts with the incentives needed to keep the banking system sound in the long run.1

Goals for the Insurance System

An achievable goal is the protection of small deposits, which makes sense, because it is not cost-effective for small depositors to monitor their respective bank’s condition. Deposit protection will reduce the household sector’s urge to withdraw funds when banking problems occur and also help to protect the retail payments system. By guaranteeing small transactions and savings balances, the deposit protection system will reduce (but not eliminate) the impact of a recession on the financial system. Protecting deposits will also help small and newly established banks compete with larger and already well-established institutions that are the beneficiaries of an implicit “too-big-to-fail” guarantee. Thus, it will counteract tendencies toward heavy concentration in the banking industry and make the banking system more open to competition through the possibility of entry by new banks.2

While many developing countries and even industrial countries lack laws or regulations for resolving insolvent banks, the initiation of deposit protection not only makes it essential to have such instruments in place, but it also offers an opportunity to establish them and the other needed elements of bank legislation, regulation and supervision. Further, a formal system of deposit protection that offers limited coverage can reduce government outlays when political considerations compel it to protect the depositors of failed banks. When citizens believe that they have an implicit guarantee, governments often feel compelled to cover a much more substantial proportion of failed bank deposits. Deposit insurance can not only reduce the total cost of covering depositors but also get banks to contribute toward meeting this cost. In addition, deposit protection can legitimately promote economic growth to some extent by encouraging savings and allowing its efficient intermediation. However, deposit protection is also sometimes used, inadvisably, to subsidize preferred industries by providing underpriced guarantees to chosen industries, such as housing in the United States until recently, or agriculture. (It is preferable to undertake any attempt at subsidization through the budget.)

Tools of Deposit Insurance

Protecting deposits is best accomplished by an independent agency that is free from political interference. The deposit insurer may be a separate department of the central bank, which may also be the supervisory agency, especially in small countries with limited financial expertise. Elsewhere, it may constitute a separate agency. The deposit insurance system needs to be well funded. Sometimes the government shares the initial cost of capitalizing the fund with the banking system. Thereafter, ongoing resources can be obtained by having banks contribute to a fund that accumulates to a target level or by imposing a levy on banks as the need arises. A deposit insurance system should aim to have sufficient financial resources to cope with the normal run of bank failures and even to deal with most periods of multiple failures.

However, a workable system cannot be expected to handle the costs of a systemic crisis involving pervasive failures. In such a situation, the government will need to provide financial assistance. Such support is appropriate when widespread failures are the result of errors in macroeconomic policy or natural or political disasters of various sorts, because the private sector cannot adequately protect itself against such events.

Pitfalls of a Poorly Designed Insurance System

There are numerous pitfalls to a poorly designed deposit protection system, but moral hazard and adverse selection can create particular problems if a system is not “incentive compatible.” Deposit insurance is unlike most other forms (life, health, property, and casualty) of insurance in several respects. “Regular insurance” involves just two parties—the guarantor and the entity protected. There are, however, three parties to a deposit insurance contract—the guarantor, the depositor, and his bank. Both of the latter benefit from the guarantee because the (small) depositor’s accounts are protected, while the bank receives a credit enhancement that enables it to raise funds at a lower rate, and shields it from widespread withdrawals by retail depositors. Further, while regular insurance usually protects against the adverse effects of independent events, particularly “acts of God,” bank failures are often not independent events but occur in waves and frequently result from mistakes made by one of the beneficiaries; that is, the bank itself.

Many different groups are affected, directly or indirectly, by the deposit protection contract and they may become subject to moral hazard. The most evident danger is that the protection extended to depositors will make them less careful initially in the selection of their bank and later will deter them from moving their funds to a safer haven. Furthermore, bank owners and managers, knowing that runs are unlikely, will take on additional risk in their asset portfolios while, at the same time, reducing the amount of capital and liquid reserves they hold to enable them to weather shocks. Further, the reduced fear of runs enables other entities that are not formally part of the insurance contract to change their behavior, sometimes in regrettable ways. For example, regulators may be reluctant to require unsound banks to take remedial action because there is no threat of market discipline to force the regulators to act. And the guarantee may provide “cover” for politicians to enable them to demand such forbearance.

Adverse selection can occur when a voluntary system of deposit protection charges premiums that are not adjusted for the risk that the bank places on the guarantee fund. In this situation the strongest banks are likely to remain outside the system or to withdraw from it if they are already members. When strong banks withdraw from a deposit insurance system, the premiums charged to remaining members have to be raised to cover the costs of paying the depositors of failed banks. The increase may induce the next strata of stronger banks to withdraw until only the weakest banks remain in the system. Such a system is unlikely to remain solvent. In short, a poorly designed insurance system can cause a deterioration in the condition of the banking system.

Best Practices

Insights from modern finance theory regarding the importance of the incentive structure for sound banking, together with experience gained by the IMF staff during the years, suggest certain elements of best practices for the creation of an incentive-compatible system of deposit protection. They are summarized in Table 1.

Table 1.Best Practices for the Deposit Insurance System in Normal Times and Departures from Them
Best PracticeDepartures from Best PracticeIssues to Be Discussed
Avoid incentive problems.Create additional moral hazard and adverse selection.A poorly designed deposit insurance system can weaken the banking system.
System explicitly laid out in law and regulation.The system is implicit and ambiguous.Transparency.
Supervisor should have a system of prompt remedial actions.There are no or late remedial actions.Should these remedial powers be mandatory or discretionary?
Resolve failed depository institutions promptly.Keep open banks that should be closed.The importance of closure policies.
Coverage should be low.There is high, even full coverage.The appropriate level and the use of coinsurance.
Membership should be compulsory.The scheme is voluntary.How to avoid adverse selection.
Deposits should be paid quickly.There are delays in payment.How to effect prompt payment.
Adequate sources of funding to avoid insolvency.The scheme is an underfunded or insolvent scheme.Underfunding can prevent the insurance system from closing banks and protecting deposits.
Risk-adjusted premiums.Flat rate premiums.How to set premiums according to risk.
Good information.Bad information.Good data are needed for supervisory discipline.
Information disclosure.Little or misleading disclosure.Accurate disclosure is needed for market discipline.
Independent agency.Political interference.How to prevent political interference but promote accountability.
Bankers on advisory, not the main board.Bankers are in control.Conflict of interests.
Close relations with lender of last resort and supervisor.Relationships are weak.Poor lender of last resort policies can raise costs to the deposit protection system.

Best Practices in Normal Times

First, the system needs to be clearly defined in law and regulation to reduce moral hazard. With transparency, all members of society know the rules under which they are operating; otherwise they cannot protect their interests. Such transparency is reinforced when the authorities move to discipline problem banks promptly to restore them to health. If deterioration continues despite remedial actions, the authorities need to close troubled banks expeditiously when (or preferably just before) they become insolvent. Prompt action also reduces the costs of resolving failed banks that gamble for redemption if they are allowed to continue in business. The supervisor needs good information on bank condition to take appropriate action. Nonproprietary information should be released to the public to support market discipline.

To reduce the problem of adverse selection, ideally a deposit protection system should charge premiums that adequately reflect the risk that each bank places on the insurance guarantee fund. While it is difficult to accurately measure such risk, several countries, including Argentina, Bulgaria, Portugal, Sweden, and the United States, currently risk-adjust their insurance premiums. In the absence of such risk-adjustment, it is essential that the protection system be compulsory. Otherwise, the best banks will refrain from joining the system or will withdraw from it. A system that includes only the weakest banks will have difficulty in meeting its obligations.

Coverage should be low enough to allow large depositors and sophisticated creditors to discipline their bank by demanding higher risk premiums from weaker banks or refusing to provide funds to these banks outright.3 Some countries use a system of coinsurance to reduce the incentive to run while maintaining market discipline. Small depositors at failed banks typically need access to their funds rapidly; thus, it behooves the system to compensate insured depositors immediately, but certainly within 30 days.

The insurance system will need funding that is adequate to meet the demands being placed on it. An underfunded scheme will prove to be an obstacle to closing failed banks and so may lead to costly forbearance.4 A scheme that relies on an accumulated fund will need to charge premiums that are adequate to build a fund sufficient to meet these demands in both normal and adverse circumstances. In the latter case, it may need to borrow temporarily to cover its needs, however. The government should either provide these funds for the deposit insurance system itself or guarantee their repayment. The system can then make a special levy on banks or raise premiums until the debt is repaid.

The insurance system should be independent from political interference, but accountable for its mistakes. Accountability can be achieved by having the deposit protection system’s report financial statements independently audited, and by requiring it to report periodically to the respective government agency involved and the public. Achieving the balance between independence and accountability will require a careful consideration of the particular political and institutional arrangements in the country designing the scheme. The system’s board of directors should not be composed of bankers, who may suffer conflicts of interest with the taxpayer. Bankers can form an advisory committee to the board, however. In small, developing countries, the insurance system may be a separately funded and administered department of the central bank; larger, developed countries may prefer to create a separate agency. This agency will not have the power to grant or withdraw bank licenses or to provide lender-of-last-resort credit to failing banks; therefore, it will need to have close and cooperative working relations with the bank supervisor and with the lender of last resort.

The objectives of the deposit protection agency can be either broadly or narrowly construed. Under a narrow interpretation, it would merely manage the fund and pay out funds due to depositors. With a broader mandate, it would also act as the receiver of banks whose licenses have been withdrawn, determine the method of their resolution, and undertake their sale or liquidation.

Departures from Best Practices

Regrettably, departures from best practices are common, and a poor incentive structure gives rise to moral hazard and adverse selection. Systems are frequently implicit and ambiguous, rather than being clearly and transparently defined. Coverage is high, leading to moral hazard. Membership is sometimes voluntary and flat-rate premiums disregard the risk a bank places on the system. When the premium level is set too low, the fund itself may become bankrupt, leading to a lack of prompt corrective action and a reluctance to close failed banks. There may be political interference that impedes supervisory action, and the insurance system’s relations with the supervisor and the lender of last resort may be impaired so that non-viable banks continue in business. Allowing weak banks to continue to deteriorate and insolvent banks to continue to operate places burdens on sound banks and typically results in a deterioration in the condition of the banking system.

Departures from best practices can occur in other areas. Insured depositors may receive their funds only after an extended delay so that the retail payments system is disrupted. Depositors, finding themselves without their transactions and savings balances, may curtail their expenditure, which can cause or exacerbate a recession. The information on which the supervisors rely when considering disciplining or closing a bank may be misleading, so that appropriate actions are not taken. The information that is released to the public may be inadequate or misleading, so that market discipline is absent. A deposit insurance system with such problems is unlikely to strengthen the financial system and can contribute to weakening it.

Adjustments to Best Practices During a Systemic Crisis

Once a widespread crisis is in progress, the government may deem it necessary to institute a full guarantee, either by creating an entirely new instrument or by overriding an existing scheme with limited coverage (Table 2). However, it should do so only for a limited period. Lindgren and Garcia (1996) discuss comprehensive coverage during a crisis and methods for removing it in due course.

Table 2.Best Practices for Deposit Guarantees in Times of Crisis
Best PracticeDepartures from Best PracticeIssues to Be Discussed
Extend full coverage.Full coverage offered too readily.When does full coverage become necessary?
It should be known that coverage is only temporary.High or full coverage is available continuously.How to remove a full guarantee?
Government backing for the fund.The fund becomes insolvent.Reconciling interests of bankers and taxpayers.

The best practice for crisis coverage is to make it clear that comprehensive coverage is a temporary measure that is distinct from the regular deposit insurance system. The government should provide the funding for such coverage. These best practices are sometimes violated by having comprehensive coverage that is extended too readily and for an unnecessarily long period of time. In addition, the government may fail to provide crisis backing for the fund, which then becomes insolvent. When the insurance system is insolvent, the authorities may be reluctant to close failed banks and the situation worsens.

Summary and Conclusions

While banks are important to the economy, they are vulnerable to illiquidity and insolvency. For these reasons, most governments have chosen to implement a financial safety net to deal with these contingencies. A system of depositor protection that guards the holders of small deposits when their bank fails has in recent years become part of this safety net in a growing number of countries. A well-designed deposit protection scheme can strengthen incentives for good governance for banks (via internal governance from owners and managers, discipline from the markets, and oversight from bank regulation and supervision), but a poorly designed system will impair all three strands of discipline and lead to a deterioration in the banking system. Consequently, good design is essential.

An insurance system faces problems of incentive compatibility for owners, managers, depositors, borrowers, regulators, and politicians. It promotes good internal governance by forcing the closure of critically undercapitalized institutions, making membership compulsory, and charging risk-adjusted premiums. It encourages sophisticated creditors to exert market discipline by providing only low coverage and disclosing good information about the condition of individual banks. Such a system and the supervisory authority both rely on political independence to limit political encouragement for forbearance. Nevertheless, both authorities need to be held accountable to avoid regulatory capture and to ensure that their actions serve the public interest.

References

    Frenkel, Jeffrey A., and Andrew K.Rose,1996, “Currency Crashes in Emerging Markets: Empirical Indicators,”NBER Working Paper No. 5437 (Cambridge, Massachusetts: National Bureau of Economic Research, January).

    Garcia, Gillian,1996, “Deposit Insurance: Obtaining the Benefits and Avoiding the Pitfalls,”IMF Working Paper No. 96/83 (Washington: International Monetary Fund, August).

    Kaminsky, Graciela L., and Carmen M.Reinhart,1996, “The Twin Crises; The Causes of Banking and Balance-of-Payments Problems,”Board of Governors of the Federal Reserve International Finance Discussion Paper No. 544, March.

    Kane, Edward J.,1989, “Changing Incentives Facing Financial-Services Regulators,”Journal of Financial Services Research, Vol. 3, pp. 26574.

    Kane, Edward J.,1995, “Three Paradigms for the Role of Capitalization Requirements in Insured Financial Institutions,”Journal of Banking and Finance, Vol. 19, pp. 43159.

    Lindgren, Carl-Johan, and GillianGarcia,1996, “Deposit Insurance and Crisis Management,”MAE Operational Paper, No. 96/3, (Washington: International Monetary Fund, December).

    Lindgren, Carl-Johan, GillianGarcia, and Matthew I.Saal,1996, Bank Soundness and Macroeconomic Policy (Washington, International Monetary Fund).

    Sachs, Jeffrey, AaronTornell, and AndresVelasco,1996a, “The Mexican Peso Crisis: Sudden Death or Death Foretold,”NBER Working Paper No. 5563 (Cambridge, Massachusetts: National Bureau of Economic Research, May).

    Sachs, Jeffrey, AaronTornell, and AndresVelasco,1996b, “Financial Crises in Emerging Markets: The Lessons from 1995,”NBER Working Paper No. 5576 (Cambridge, Massachusetts: National Bureau of Economic Research, May).

Garcia (1996) discusses the trade-off between short-term assurances and long-term stability and issues relating to deposit insurance in greater depth.

When entry is feasible, banking is “contestable” in the parlance of microeconomics.

Coverage that extends to one or two times per capita GDP is a suitable rule of thumb.

The best-known example of an insolvent insurance scheme is perhaps the Federal Savings and Loan Insurance Corporation in the United States, which practiced forbearance for a number of years with costly consequences for U.S. taxpayers.

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