Abstract

The proliferation of banking and financial crises during the 1980s and 1990s has led a large number of countries to institute, or consider instituting, an explicit system of deposit insurance (see, for example, Lindgren, Garcia, and Saal, 1996).2 In fact, 30 of the 72 countries now known to have an explicit deposit insurance system established it during the past decade; 49 set up their systems in the past 20 years. During the 1990s, 33 countries reformed their deposit insurance systems, often to improve its incentive structure in light of experience.3

The proliferation of banking and financial crises during the 1980s and 1990s has led a large number of countries to institute, or consider instituting, an explicit system of deposit insurance (see, for example, Lindgren, Garcia, and Saal, 1996).2 In fact, 30 of the 72 countries now known to have an explicit deposit insurance system established it during the past decade; 49 set up their systems in the past 20 years. During the 1990s, 33 countries reformed their deposit insurance systems, often to improve its incentive structure in light of experience.3

Countries often have several objectives when they establish a deposit insurance system. Some of these objectives are achievable; others are not. One of the most common goals is to avoid an imminent systemic crisis or resolve an existing one; but this objective is regrettably unrealistic. The incompatibility arises because achieving it will, most probably, require a full guarantee, which conflicts with the incentives needed to keep the banking system sound in the long run. This part of the paper discusses deposit insurance systems only in normal times. As discussed in Section IV, a separate response may be needed to manage a contagious, systemic crisis, which may require overriding an existing deposit insurance system. Thus, an attempt to replace a full implicit guarantee by a limited deposit insurance system when the banking system is confronting significant problems is likely to be ineffective. Deposit insurance system initiation must wait until after the banking system has been recapitalized and restructured.

Under the deposit insurance system option, national regulators rely on both discipline from the markets and prudential regulation and supervision, including surveillance over the payment system, to counter the incentive problems and excessive risk taking that accompany deposit insurance. They use the lender of last resort to deal with liquidity problems of solvent banks and counter possible runs by large, informed depositors. (The lender of last resort confronts a practical problem, however. Typically, an insured bank can remain liquid long after it becomes insolvent and the central bank has difficulty in distinguishing illiquid but solvent banks from those that are both illiquid and insolvent.) The authorities also need to require data disclosure to the public in order to help depositors and other creditors exercise market discipline on banks. They enforce standards for adequate bank capitalization to avoid insolvencies, maintain other regulatory standards to assure good governance, limit excessive risk taking, and enforce firm entry and exit rules to keep the system sound.

As Table 1 suggests, it is essential to design an incentive-compatible system that discourages the pitfalls of deposit insurance—moral hazard, adverse selection, and agency problems. That will necessitate having appropriate objectives for the deposit insurance system, carefully construed roles and responsibilities for it, and a supportive infrastructure that ensures good internal and external governance for insured institutions. In implementation, the components of this framework will vary from country to country.

Table 1.

Good Practices for Deposit Insurance

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Note: These good practices are applicable in normal times. Good practices during systemic crises are described in Section IV.Sources: Developed from Folkerts-Landau, Lindgren, and others 1998) and Garcia (1999, 2000).

Objectives

Countries implement deposit insurance systems for a number of reasons. As Garcia (1996) discusses in more detail, these reasons include: (1) providing consumer protection for small depositors by providing a mechanism for the immediate pay-out or transfer of the insured portion of their deposits; (2) enhancing public confidence and systemic stability by establishing a framework for the resolution of failed banks that deals sternly and expeditiously with individual bank failures and so prevents them from spreading; (3) increasing savings and encouraging economic growth; (4) enabling small and new banks to compete with large and/or state-owned banks: (5) defining the boundaries of the government’s exposure to loss when a bank or group of banks fail in normal times; and (6) requiring banks to contribute to the resolution of failed peers. In sum, protecting small depositors and enhancing stability by strengthening the incentive structure, which includes a strong exit framework, should be the principal reasons for adopting a deposit insurance system.

Most countries, including those that are members of the European Union, emphasize small-depositor (consumer) protection as the main objective of their deposit insurance system. A system could be expected to cope with isolated and even multiple bank failures, if the deposits involved comprise a reasonably small percentage of total system deposits.4 A properly designed scheme can help to eliminate self-justifying runs by small depositors and so contribute to the overall stability of deposits and the banking system. Moreover, a stable pool of small, core deposits enhances a bank’s franchise value and so facilitates the timely and orderly resolution of weak banks, which serves to keep the banking system efficient. In this way, deposit insurance can also establish a more rational system for forcing the closure with restructuring, rather than the liquidation, of nonviable banks. A deposit insurance system also promotes competition in that it assists small banks to compete with larger banks that may be deemed “too big to fail.”

The first principle suggests that all depository institutions, including commercial, investment, merchant, savings, cooperative banks, finance companies, and credit unions that offer par valued deposits to the public, should be covered by deposit insurance.5 The deposit insurance system will need to provide incentives to contain the pitfalls of deposit insurance—moral hazard, adverse selection, and agency problems. And insured banks will need close supervision to bolster the incentive structure.

However, countries often harbor unrealistic expectations for deposit insurance. It is not an appropriate vehicle for providing preferences to politically favored industries—that is a fiscal responsibility. Moreover, the elimination of runs on all categories of deposits is not a viable objective for deposit insurance. Limited coverage will not protect large, wholesale, or inter bank deposits (both domestic and foreign), which are the deposits most prone to runs. Once a systemic crisis develops, limited-coverage deposit insurance will not protect the large-value payment system nor prevent a flight to quality, flight abroad, or the collapse of the system. Thus, a well-designed deposit insurance system can be, at best, just one component of a sound financial system.

The Deposit Insurance System’s Mandate: Public or Private

A privately run scheme will benefit from peer pressure to keep the system sound and avoid costs to members, but it may not be able to cope with widespread failures. In turn, the choice between a public and a private system will influence the scope of the deposit insurance agency’s functions.

There are two legitimate and contrasting models governing the ownership of the deposit insurance system under normal conditions. Both are already in existence around the world. One is privately run and entirely privately funded, and the other is government-backed and run. Argentina has a privately funded and privately run system. The United States has a government-run system that is privately funded but has explicit government backing. (There are also instances of privately funded and privately run insurance systems that have, usually informal, government backing: but these are likely to give rise to conflicts of interest.) While the private deposit insurance agency could have a limited agenda, a government-run insurance agency could have wider roles and responsibilities.

The deposit insurance system will be successful only if it is financially viable and has earned the public’s confidence. There also should be clear understanding as to who will back up the system if it should become insolvent or illiquid, and under what circumstances support will be provided. When banking problems are severe, the system will, most probably, need government backing. A privately run system may lack credibility without such government support. But if it has that support, it may be tempted to set premiums too low for financial self-sufficiency under the assurance that the government will cover the financial gap. For this reason, the deposit insurance system in many countries will need to be run by a government agency to protect the public interest and the taxpayer from loss.6 Regardless of who runs the system, it will need a good legal framework, as discussed below.

The System’s Mandate: Narrow or Broad?

A deposit insurance system can embrace a wide range of responsibilities, but fundamentally its man date may be either narrow or broad. It is important to establish a clear understanding of the role and responsibilities of the deposit insurance agency or authority so that it can fulfill its obligations effectively and adopt an appropriate organizational structure. This understanding, especially where membership in the insurance system is limited, allows for modes staffing.

The Narrow Mandate

A narrow system may be merely a “paybox” that compensates insured depositors of failed banks. Its principal responsibility will be to:

  • Insure small depositors in member institutions. Doing so will involve verifying depositors’ claims and paying out or transferring deposits to another bank when called upon to do so by the supervisory authority.

  • Compensate insured depositors in failed member institutions promptly to minimize disruption to the economy. Delaying payment/transfer diminishes the value of the guarantee and dishonors public trust.

Additional responsibilities include:

  • Setting and collecting premiums. Premiums can be assessed quarterly or semiannually based on the reports banks submit to their supervisors. Setting premiums is discussed later.

  • Managing the insurance fund in a way that allows it to satisfy its obligations effectively, keep insurance premiums low to protect member institutions’ interests, and maintain the soundness of the banking industry. This implies that the fund’s resources be invested in safe assets. (See the section “Promoting Credibility.”)

  • Informing the public of its role and responsibilities and describing how it works.

Once the bank is intervened or placed in receivership/liquidation, ownership of deposits should be verified and the amount that is covered in full should be made available rapidly.7 A well-prepared deposit insurance agency can make (full or partial) payment over the weekend when a bank is closed on a Friday, but certainly within 30 days. Compensation can be made in a number of ways. Paying out deposits in cash should be avoided, if possible. Where payouts have to be made, however, payment through automatic teller machines (ATMs) can be an efficient option. A preferred option is to transfer insured deposits from an intervened bank to another institution that is willing to take them and even to pay a premium to receive them (along with a negotiated amount of the failed banks’ or other assets). The recipient bank will make the insured deposits available to their owners by opening accounts for them, or provide a refund in person or by mail. Regardless of the method, the funds should be accessible within one or two days to protect the payment system and to avoid runs on other banks by small depositors, for whom it is not cost effective to evaluate the safety of their bank, even if they have the sophistication and information to do so.8

Supervisory authorities sometimes need to suspend deposit withdrawals. While they should seek to avoid suspension or limits on the amount that can be withdrawn, authorities may need to use such measures to permit valuation and loss-sharing. In such cases, the restrictions should apply only to large deposits. Small depositors should retain access to limited amounts of their funds. Moreover, the suspension should stay in place for the shortest possible time.

In setting up the relationship between the supervisor and the deposit insurance system, policymakers should take the following into account:

  • Deposit insurance agency staff in a privately or jointly run agency must analyze information received from the supervisory authority and elsewhere to protect the insurance fund. Clear lines of communication between the agency and the supervisor need to be worked out, since the agency must be aware of which individual institutions could pose a risk to the insurance fund. All information and decisions pertaining to banks gathered by the agency must be classified as strictly confidential, and agency staff should be subject to the same confidentiality rules as supervisors. Providing information to bankers in a privately run deposit guarantee is, therefore, a problem.

  • The deposit insurance agency must communicate its concerns over problem banks to the supervisor. Initially the agency could express its concerns verbally. Later, it should do so in a formal written communication to the head of the supervisory agency. Subsequently, if no action or inadequate action has been taken by supervisor, in a publicly backed scheme, the agency must notify an appropriate government agency of its concerns. This agency will often be the ministry of finance, because it is the ministry that will ultimately have to meet any deficiency in the system’s funds.

The ultimate in a narrowly defined deposit insurance agency would be one that is a separate legal entity in concept only. It could delegate some or all of its responsibilities to the central bank, the bank supervisor, or to the ministry of finance.

The Broad Mandate

Under a broader construction, the deposit insurance agency may also:

  • Monitor the condition of the banking industry to estimate its potential losses and take actions to minimize or forestall those losses.

  • Take responsibility for the resolution of insured financial institutions that have been intervened by the supervisory authority. Institutions should remain the responsibility of the supervisor until they have been intervened. Under the supervisor’s authority, they will be subject to a range of corrective measures, including statutory prompt corrective action, whereby the supervisor may take temporary control of the institution and install new management. Once the supervisor has intervened in an institution and taken it permanently from its owners, responsibility for it should immediately pass to the deposit insurance agency.

Apart from compensating insured depositors promptly, the broadly defined agency has a fiduciary responsibility to avoid losses and to obtain as much as possible for the failed bank’s portfolio. A more detailed discussion is beyond the scope of this paper, but it may be possible to merge an entire failed entity into another institution, or to pass a negotiated portion of assets to another bank together with the insured deposits in a purchase and assumption transaction. Otherwise, it may be necessary to liquidate the assets in full or in part. Resolution powers should be granted to the agency by law, and it should use a combination of methods of resolution that is least costly to it (on the basis of discounted present value over a relevant time horizon).

In a systemic crisis, however, a special agency may have to be established to cope with a flood of insolvencies and the disposal of a large volume of assets from failed banks.9 While the deposit insurance authority also could be assigned such additional functions as restructuring and liquidating banks, these aspects go beyond the topic of depositor protection and are not covered in this paper. However, these additional powers need to be clearly anchored in the law.

Infrastructure

Both public and private deposit insurance systems need to be supported by a strong infrastructure of civil and commercial law to strengthen property rights. A clear understanding of their fiduciary responsibilities by bank owners and managers will enhance internal governance. Internationally accepted accounting and auditing standards will facilitate realistic loan valuations and empower market discipline. Public disclosure of individual bank data will also encourage market discipline.10 The system also needs to be supported by a well-formulated lender of last resort and adequate risk-management framework in the payment system. These and other relevant topics are beyond the scope of this paper, but attention will be given to supervision and regulation, which need to be buttressed to make the deposit guarantee successful.

Supervision, Regulation, and Resolution

The regulatory and supervisory system should require fit-and-proper owners and operators, enforce rules for governance and capitalization, limit risk taking, require information disclosure to the public as well as the supervisor, and execute a set of prompt co1 reactive actions to forestall and, if necessary, swiftly resolve insolvencies (see Folkerts-Landau and Lindgren, 1998).

The supervisory authorities should force the strict resolution of problem banks, using a swift application of a spectrum of enforcement actions to be taken as soon as a bank becomes undercapitalized or shows other signs of weakness. The objective is to turn the weak bank around toward recovery before it becomes nonviable and places burdens on the deposit insurance system. A system of prompt corrective actions, sometimes also called structured early intervention and resolution (SEIR), is a key component of an efficient and competitive banking system.11

Requiring and enforcing capital requirements also protect the deposit insurance system. They serve a similar purpose to that of a high deductible in property and casualty insurance in making the insured party reluctant to take excessive risks. In addition, preventing undercapitalized banks from paying dividends or making side payments to their owners and managers will make it more difficult for these parties to loot the bank (Akerlof and Romer, 1993). While restricting the insured bank to holding only safe assets (narrow banking) or collateralizing insured deposits with relatively risk-free assets will also serve to diminish the number of bank failures and the cost to the insurance fund of resolving those that do occur, narrow banking has practical limitations and foregoes many of the natural synergies of banking. (Further discussion of narrow banking lies beyond the scope of this paper).

Prompt corrective action/SEIR should allow supervisors to intervene in a problem bank before it becomes book-value insolvent and provide the basis for the prompt closure of the bank should it become necessary.12 Almost universally, experience has shown that an onsite examination or external audit of a bank that is approaching book-value insolvency reveals that the provisions for loan losses are inadequate. Thus, such a bank is, in fact, already insolvent at current market value—and often deeply so—and will be found to be insolvent at book value once a proper asset valuation is made. Delay in closure almost always deepens the costs of a bank’s insolvency, partly because owners can abuse the deposit insurance system, loot the bank, and/or gamble for recovery with those deposit funds that remain in place and with new deposits that are attracted by higher interest rates and the fact that they are guaranteed.

Instead of delay, the supervisor, or the deposit insurer when it has a broad mandate, needs a strong framework for the resolution of failed banks that encourages the owners and managers of each bank to keep their bank strong and retain control over it. The supervisor needs authority to close and liquidate or resolve insolvent banks in some other incentive-compatible manner.

Supervisors often express a preference for exercising regulatory discretion in disciplining or closing a problem bank. Yet, having discretion exposes supervisors to political interference, and experience has shown that they may be pressured to use that discretion inadvisably to postpone corrective actions. The optimal balance between rules and discretion will vary from country to country according to local conditions, such as the efficiency of the legal system, strength of the civil service, and political tradition.

Requiring Subordinated Debt

Subordinated debt—debt that ranks behind other non-equity claims in a liquidation—has a dual role in strengthening the banking system. As an addition to the bank’s equity capital, it acts both as a buffer against losses and a market signal of bank condition. As a junior debt, or quasi-equity. subordinated debt can be written down more easily than deposits or unsubordinated credits. The subordinated debt contract should make clear to holders their exposure to loss in the situation where the bank is closed.

This useful function has led a number of regulators and economists to advocate an increased role for subordinated debt in the capital structure of large publicly traded banks.13 Under such proposals, large banks at all times should be required to issue subordinated debt that has been rated by an acceptable rating agency equivalent to, at least, 2 percent of their assets. Some of this debt should be short term, so that the bank needs to reissue its subordinated debt frequently. The ease or difficulty of the issuance process and the contractual terms of the issue will give the bank’s supervisors additional information on the markets’ perceptions of the bank’s condition. Moreover, this capital would be exposed to loss sharing.14

Subordinated debt is not a substitute for a deposit insurance system, but it could be a useful complement. Requiring subordinated debt is feasible only for large publicly traded banks, and issuance of such debt would be difficult, even for large banks, in undeveloped markets. In Argentina, which appears to be one of the few countries to have set a subordinated debt requirement to date, critics argue that the market is thin, with virtually no secondary market, and that bank owners can rig the market by buying the debt.15 Canada has considered, but not adopted, a proposal to require subordinated debt.

A Framework For Resolving Individual Banks

All countries need a firm framework for the resolution of troubled banks. If it does not already exist, the establishment of a system of deposit insurance provides an opportunity to design and enact a legal and institutional framework that will help authorities to intervene in, sell, or close troubled banks—in whole or in part. Such a clear legal framework will foster early action in the resolution of problem banks and will help to avoid costly delays, thus expanding the opportunities for the resolution of individual banks to keep the financial system sound. However, there is a need to make certain that the legal framework for the deposit insurance system is also adequately reflected in the banking law, and that it does not conflict with other laws (e.g., company law, the code of commercial and personal bankruptcy, etc.).

In the case of a broad mandate, the resolution framework should require that the bank pass to the government-run deposit insurance agency for resolution immediately after it has been intervened by the supervisory authority. The agency would then compensate insured depositors, write down shareholders’ equity, and impose losses (“haircuts”) on uninsured depositors and unsecured creditors. The power to do so would be granted to the agency by law. The agency would seek to merge a failed bank with another bank, conduct a purchase and assumption transaction, oversee a liquidation, or combine any of these actions with the aim of minimizing its own cost, but it would have no authority to provide open bank assistance, for example, by infusing liquidity or providing capital to a bank that has not been intervened. The problem with open bank assistance is that it can be too easily abused to bail out owners.

Too Big to Fail

Country authorities and markets frequently consider some banks to be “too big to fail.” that is, too big to be closed and liquidated.16” There are arguments for and against such a policy. On the one hand, the too-big-to-fail argument tends to be excessively invoked by authorities as an excuse for not taking failed banks from their owners—often for political reasons. On the other hand, many banking systems are heavily concentrated and the closure and liquidation of a bank representing, say, more than 10–20 percent of a banking system’s assets could have major systemic implications.17 As long as the owners and managers of a failed bank are not bailed out and there is an operational and financial restructuring to restore viability to the bank, a too-big-to-fail policy means that the state saves the economic infrastructure of the bank, absorbs the losses, and often assumes ownership temporarily until reprivatization (see Enoch, Garcia, and Sundararajan. 1999). However, too-big-to-fail arguments cannot be invoked repeatedly. If the initial restructuring measures do not make a bank viable, more drastic measures to resolve failed banks should be taken. These measures could involve splitting up the bank, partially liquidating it. or engineering a major shrinkage of its balance sheet through structural and/or operational downsizing.

Country Specifics

Many standard features should be present in a deposit insurance system, but also many country-specific conditions must be taken into account. Deposit insurance is best suited for an economy with a relatively large number of banks operating according to the same rules. However, these conditions are often not present and the most difficult cases in which to consider a deposit protection are banking systems that have a very skewed structure in terms of: (1) size—that is, one or a few very large banks and some or many small ones: (2) ownership—that is, a few dominant state-owned banks that may carry explicit or implicit guarantees of all their deposits; and, more important (3) soundness—that is, a few well-managed and solvent banks together with a significant number and share of insolvent and/or nonviable banks. As mentioned above, under (1) and (2) a deposit insurance system would require very careful design, while under (3), as further discussed in Section III. insurance would best be postponed until after the weak banks have been restructured.

Concentration

Any system of insurance seeks to diversify its risks across a number of participants in order to overcome regional or industry-specific shocks and to share the costs of failures. In many countries, however, the banking system is highly concentrated and in others concentration will follow restructuring in the aftermath of a crisis. Consequently, in these countries, it will not be possible to diversify risks across a large number of member institutions. As a result, the question must be posed whether any system of privately funded deposit insurance can work in a country with a concentrated banking system. The failure of a very large member could overwhelm a privately funded system. Private funding promotes good incentives, but leaves the system vulnerable to the collapse of a large member, raising the question: is a deposit insurance system feasible in a highly concentrated banking system?

This report suggests that a privately funded system can work and can result in a number of advantages, which may (or may not) be judged sufficient to outweigh a problem of moderate to high concentration. Insurance premiums might need to be higher than those in a country with a more diversified banking system, but this problem may be outweighed by the system’s three advantages—namely, the establishment of a structure for resolution of problem banks and for distributing losses in case of bank failures, the creation of a framework for sharing the costs of individual bank failures, and the building up of an insurance fund to help pay for any losses. The deposit insurance system may replace an existing blanket guarantee of all depositors and creditors with limited coverage for small depositors. This limitation seeks to overcome the problem of excessive coverage and resulting moral hazard. More fundamentally, deposit insurance can make the banking markets contestable, if not perfectly competitive, by allowing for the possibility of new entrants into the industry.18

Ownership: State-Owned Banks

Governments commonly institute a system of deposit insurance when there are a few, large state-owned banks that have implicit guarantees and a number of smaller or newly-chartered private banks. The government may be in the process of privatizing the industry, may be concerned about the condition of borrowers, and may want to help the new institutions prosper, even though it buttresses competing banks with an implicit or explicit comprehensive guarantee. As discussed further in Section IV, the state banks’ full guarantee will be removed in time. However, including both private and guaranteed state institutions in the insurance system helps to build the system’s resources and somewhat redress the state institutions’ competitive advantage. The process may work, as long as the banking system remains sound for long enough to allow the government to phase out the full guarantee. If a crisis hits soon, however, the public is likely to favor the fully guaranteed banks over the smaller private institutions and runs on the latter may ensue.

Fragility

A limited, explicit system of deposit insurance should be installed when the banking system is sound. As discussed further in Section IV, that means bank restructuring needs to have been successfully accomplished before the system is implemented. The system can be planned, the legislation prepared, and the industry and public informed of its pending arrival during the restructuring process so that it is an integral part of the measures being taken. But it should not go into operation until all interested parties agree that the financial system is strong enough to withstand the financial and administrative demands that deposit insurance will place upon it and until rules ensure that losses will be equitably and efficiently distributed.

Countries are often impatient and reluctant to wait for this opportune time, however. But starting a system of deposit insurance will not relieve them of their responsibility to cleanse the banking system first. Deposit protection can postpone a banking debacle, but it is unlikely to prevent one. Moreover, delaying resolution can exacerbate weak banks’ problems by allowing them to gamble for recovery and lose, and, in so doing, magnify the costs of failure resolution and the possibility of contagion.

But a country may have more legitimate reasons for starting a system of deposit insurance. It may want to increase savings, encourage the development of the banking system, and modernize the payment system. In this case, it may announce that an insurance system will commence in one to two years with membership that will be restricted to sound, eligible institutions. In the interim, the supervisor, in consultation with the incipient system, will determine which institutions are sound enough to qualify. The supervisor should notify those institutions not considered sufficiently sound and give them one year to meet the desired standards. Those that do not qualify would be excluded from the system, which would probably lead to their demise.

If the government were to authorize a system of deposit insurance while banks that are too weak to join are still operating, it risks runs, possibly systemic runs. Where the number and size of the weak nonmembers is small, danger to the system may not be great but the government must be prepared to take over and resolve those banks that the public judges to be nonviable. If the number and/or the size of the weak banks is large, the government should wait to install a system until the banking system is stronger.

Avoiding Moral Hazard

As mentioned earlier, deposit insurance can create incentive incompatibilities that weaken the banking system and make the cost of insurance prohibitive. Thus, a deposit protection system needs to be designed to provide a set of inducements (that include both positive and negative reinforcements—“carrots and sticks”) to encourage all of the parties involved (small depositors, large depositors, and other creditors, owners, boards of directors, managers, borrowers, supervisors, judges, government officials, and legislators) to act in ways that serve to strengthen the banking system (Kane, 1992).

To avoid the pitfalls of poor incentives and high cost, a system of deposit insurance should include several standard features, which are summarized in Table 1. For example, to minimize moral hazard, the system should be explicitly and clearly established in the law so that all bank customers know the rules under which the system operates. As discussed earlier, those rules include the supervisors having a system of prompt remedial actions to remedy bank problems and power to close or otherwise resolve failed depository institutions promptly when remedial action is not successful. In addition, deposit coverage should be low.

This section discusses steps that can be taken to contain moral hazard, including obtaining and publishing information on the condition of individual banks, choosing which financial instruments to cover, and which to exclude, setting the level of coverage, considering adopting coinsurance, netting outstanding loans against deposits, and determining who shall have priority over the assets of the intervened bank.

Make the Deposit Insurance System Transparent

Transparency is essential because it allows bank customers to protect their interests. Transparency requires explicitly defining the deposit guarantee in law and/or regulation, clarifying what qualifies as an insured deposit, allowing the supervisor to have information on individual banks (which allows swift remedial actions), and disseminating nonproprietary information to the public.

Explicitly Define the System in Law and/or Regulation

Explicitly formulated systems have advantages over implicit schemes. For example, the rules of the system (particularly those relating to limited coverage) that are known to the public and adhered to by the authorities promote good governance by owners and managers and encourage discipline by sophisticated creditors. Making the laws and regulations transparent and disclosing bank-specific information allows the public to protect its interests by requiring interest rate premiums from banks that have risky portfolios and judiciously entrusting their funds to the soundest banks. Such restraint on risk taking reduces the government’s exposure to loss when banks default because it want a bank’s large customers that taking excessive risks can be costly to them.

Define Deposits

It is the juxtaposition of the characteristics of a bank’s assets (which are typically longer-term, illiquid, and difficult-to-value loans) and its liabilities (which are mainly deposits) that make banks vulnerable to runs. While different countries include different instruments in their classification of “deposit,” the essence of the debt instrument is that it is repay able at par, often on demand.

One of the most crucial pieces of information that the public needs is a clear and enforceable definition of what is a deposit. The definition of a deposit—its principal and interest—will need to be clearly defined in law; regulations can provide specific details. Precision and legal enforceability are important in order to provide certainty regarding coverage and to facilitate the resolution of disputes. The definition of “deposits” should be consistent with those adopted under other banking laws and regulations. Thus, the definition chosen may vary from country to country.19 Clear definitions will avoid much of the uncertainty and potential litigation that could otherwise occur after an institution is closed. Such definitions will also be needed to enable the deposit insurance agency to calculate the premiums (or ex post assessments) that member institutions must pay.

Both the deposit insurance agency and the institutions covered by that agency carry a responsibility to publicize which deposits are insured and which are not. The public has a right to know this, in order to protect its interests. Coverage needs to be specified in advance, and not be subject to interpretation after a failure has occurred. In each deposit or borrowing document, the issuing institutions would have to indicate in conspicuous print (to be stipulated in guidelines) whether it is insured by the deposit insurer or not. Requiring other nonbank financial institutions to disclose in each deposit/borrowing document that their instruments are not covered by deposit insurance would also need to be considered.

Information for the Supervisor and the Deposit Insurance Agency

To institute prompt remedial actions and effect speedy intervention when necessary, the supervisor needs accurate and timely information on the condition of each bank. That information is derived primarily from reports submitted by banks and from onsite inspections. But supervisors may also look to the markets for indications of bank condition. Having to pay premium interest rates on both retail and wholesale (including interbank) deposits or other liabilities including subordinated debt, or losing their ability to obtain funds, suggest that the supervisors should closely monitor the bank.

The deposit insurance authority with a broad mandate needs to know the condition of the banking industry in general and of weak institutions that might impose costs upon it so that it may plan for payouts and choose resolution strategies. Further, it needs data on the national distribution of deposits by size, so that it can choose where to set coverage limits, and the distribution in individual weak banks, so that it can forecast the financial demands that might be placed upon it. The narrowly focused agency needs data on the deposits that it guarantees.

Finding a way for the supervisor in a deposit insurance agency to share information and satisfy each agency’s specific information needs is a challenge. Sharing is preferable, in the main, to duplicating oversight responsibilities, but country practices in this regard differ indeed. Good practices for sharing information with domestic or foreign supervisors are still being developed. However, the law should specify what information the deposit insurer is entitled to receive and what information the supervisor is obliged to convey promptly. Where the deposit insurance authority has a narrow range of responsibilities, the flow of information on the condition of the banking industry in general, on individual institutions, and, particularly, on vulnerable institutions, and on deposit levels will be one way—from the supervisor to the deposit insurance agency. However, where the deposit insurer has a broader role and independent sources of data, the law should require that the agency should reciprocally share its own information with the supervisor. The law should also require that agency staff obey the same rules as supervisors regarding the confidentiality of information.

Disseminating Information

Supervisors will want to disseminate as much of their information as is competitively equitable to enable the public to protect its financial interests and to help keep the banking system sound through market discipline. Accurate information will also help to avoid unnecessary runs against sound banks. The supervisor must also make arrangements to share a larger portion of its bank-by-bank data with the deposit insurance agency so that it is not blindsided by the unexpected failure of one of its member institutions. Sharing information is more problematic where the deposit insurance system is privately run. In this situation, questions of confidentiality and competitive fairness arise.

Coverage

Issues related to coverage include deciding which classes of depository institution should be required to join the system of deposit insurance, which financial instruments to cover, and to what extent to cover them.

Which Institutions to Cover?

Clearly those institutions that offer deposits are the prime candidates for coverage by the system of deposit insurance. Including a wide range of institutions in the system in order to diversify its risks has advantages, but these advantages are not always compelling. Where some institutions are not subject to the same stringent prudential regulations as commercial banks, they may be excluded from the system. A country may choose to institute a separate scheme to cover such depository institutions. This scheme may offer lower coverage, or charge higher premiums in order to cover the additional risks attendant on inferior prudential oversight.

Which Instruments to Cover?

This section discusses which instruments to cover by deposit insurance and the limits on, and exclusions from, coverage. It is administratively simpler to protect deposits of all types rather than to confine coverage to natural persons or to exclude certain deposits. Administrative simplicity can accelerate compensation, and promptness in payment is critical to the credibility of a deposit insurer. (This principle is often overlooked, as the survey in Section III shows that payment is typically slow.) Excluding classes of deposits and depositors delays payment. The following bullet points list the types of deposits to be included, and establish that both principal and interest would be covered.

  • Deposits of all types, including demand, savings, and time deposits that are denominated in domestic currency, should be covered.

  • Promissory notes that are often issued by finance companies would be covered by the system if finance companies are allowed to join the scheme, and if they are defined by law and/or regulated by the deposit insurance agency as deposits.

  • Both principal and any accrued interest that has not already been added to the principal would be covered. Interest coverage could be determined on the basis of what has been hooked at the date of intervention, even if it has not yet been added to the principal. Where it is general practice to credit interest frequently to a depositor’s account, not covering interest would be more time consuming and costly to administer than covering it. However, depositors in troubled institutions typically receive higher interest rates. The deposit insurance authority should have no obligation to pay such high rates after taking charge of an institution. Consideration might be given to imposing a cap (for example, the average rate paid by the five largest banks for any maturity) on the rates paid on deposits in failed banks.

  • The coverage to be provided for the deposit of trusts, managed, and provident funds would have to be defined. For trust accounts, one person should be designated to represent the group, which would be entitled only to coverage for a single person.

Foreign currency deposits. The decision whether to cover deposits denominated in foreign currencies is more complex. The choice will depend on the country’s particular circumstances. Where most transactions are conducted in the domestic currency and the total value of retail foreign currency deposits is small, the authorities may choose not to extend coverage to deposits of foreign currency, without risking runs. But where foreign currency deposits are widely used, and particularly where the country is dollarized, the deposit insurance system may insure foreign currency deposits to promote financial stability.

Guaranteeing that deposits will be repaid in foreign currencies exposes the deposit insurer to risks that are not easily managed. Consequently, a number of countries compensate individual holders of foreign currency deposits in domestic currency. This is the appropriate choice. The law or regulation governing coverage must spell out that the conversion from foreign to domestic currency will be made at the exchange rate that prevails at some uniform and clear specified time. Yet even providing to pay foreign currency deposits in domestic currency will not protect the system from the loss it will incur if the domestic currency depreciates after the deposit is made.

Which Instruments to Exclude?

Although there are advantages to covering deposits of all types up to a low coverage limit, experience has shown that countries exclude a number of categories of deposits from coverage for a variety of reasons. The European Union Directive on Deposit Guarantee Schemes permits these exclusions and a number of countries have adopted them. A list of items that can be excluded from coverage under the deposit insurance directive appears in Box 1. The survey in Section III details country practices regarding exclusions.

  • The exclusion of bearer instruments can be justified because it would be impossible to implement the required limitations on coverage.

Exclusions from Deposit Insurance Coverage

Article 7(2) of the European Union’s Directive on Deposit Insurance permits member countries to exclude certain categories of deposits from coverage. The exclusions are not mandatory. The exclusions (laid out in Annex I to the Directive) are listed below.

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ANNEX I

List of exclusions referred to in Article 7(2)

  1. Deposits by financial institutions as defined in Article 1(6) of Directive 89/646/EEC.

  2. Deposits by insurance undertakings.

  3. Deposits by government and central administrative authorities.

  4. Deposits by provincial, regional, local and municipal authorities.

  5. Deposits by collective investment undertakings.

  6. Deposits by pension and retirement funds.

  7. Deposits by a credit institution’s own directors, managers, members personally liable, holders of at least 5% of the credit institution’s capital, persons responsible for carrying out the statutory audits of the credit institution’s accounting documents and depositors of similar status in other companies in the same group.

  8. Deposits by close relatives and third parties acting on behalf of the depositors referred to in 7.

  9. Deposits by other companies in the same group.

  10. Non-nominative deposits.

  11. Deposits for which the depositor has, on an individual basis, obtained from the same credit institution rates and financial concessions which have helped to aggravate its financial situation.

  12. Debt securities issued by the same institution and liabilities arising out of own acceptances and promissory notes.

  13. Deposits in currencies other than:

    • those of the Member States;

    • ECU’S.

  14. Deposits by companies which are of such a size that they are not permitted to draw up abridged balance sheets pursuant to Article 11 of the Fourth Council Directive (78/660/EEC) of 25 July 1978 based on Article 53(3)(g) of the Treaty on the annual accounts of certain types of companies.1

1 OJ No. L 222, 14.8.1978, p. 11. Directive as last amended by Directive 90/605/EEC (OJ No. L 317. 16.11.1990. p. 60).

Other Nonessential Exclusions

It is not essential to exclude insider deposits (e.g., those pertaining to owners, managers, and their families). Insiders often receive special privileges, such as priority in bank lending, and such loans can weaken a bank, but these problems can be prevented by careful supervision and dealt with by the legal system should supervisory prevention fail. Some countries exclude deposits carrying excessively high interest rates from coverage. Paying high rates can indicate that the institution is weak, is bidding up rates to retain funds, or is trying to grow and gamble for recovery. Such actions can harm social competitors when they raise the general level of rates paid on deposits. However, the supervisor should deal with such problems rather than encumber the deposit insurance system with a supervisory responsibility. Similarly, the judiciary should deal with problems relating to money laundering and other illegal activities. The deposit insurance agency cannot address these problems by excluding illegal deposits from coverage. Many countries in the survey excluded interbank deposits, but if coverage is low. including them in the guarantee will not encourage moral hazard.

Extent of Coverage

To fulfill its basic mandate of protecting consumers, the deposit insurance scheme should be designed to protect small depositors who are likely to have low incomes, be unsophisticated in the ways of banks and lending, and lack the time, information, and means to study the condition of their bank. Excluding larger depositors and unsecured creditors from coverage, thereby exposing them to loss, will cause these depositors to monitor the condition of their banks carefully and to impose market pressure on the banks to remain sound. This discipline will support the supervisors’ efforts to encourage institutions to remain strong. The presence of deposit insurance also removes two of the obstacles to taking stern measures to resolve nonviable institutions—the fear of imposing losses on small depositors, and the political repercussions of doing so. In turn, the fear of closure will encourage remaining banks to maintain high standards.

Coverage for Each Deposit or Each Depositor?

Compensation should be paid up to the limit on the sum of deposits held by one individual depositor in any member institution. Holders of joint accounts would elect one of the group as the primary depositor, and coverage would apply to him/her in conformity with national law. Currently only a few countries deviate from this arrangement. Some (the United States and Canada) offer more generous coverage on joint and retirement accounts. Others offered coverage on each and even deposit in an institution, but no longer do so. It would be possible to impose a limit on the number of times that claims for insurance can be filed in any year or over a lifetime, but there has been limited interest in doing so.

The problem with coverage per deposit is that it would allow a depositor to easily guarantee a large amount of funds in different accounts within a single institution. The European Union has moved away from coverage per deposit and toward coverage per depositor since the EU Directive on Deposit Guarantee Schemes was issued in 1994. It remains possible for a depositor under coverage-per-depositor to obtain multiple coverage by diversifying his/her funds across accounts in different institutions, which is an attractive way for depositors to limit their exposure. Nevertheless, coverage-per-depositor does not extend coverage to large aggregate holdings in individual banks.

Amount of Coverage

The aggregate amount of coverage offered to each depositor in any bank should be relatively low. As a starting point, coverage could be considered in the region of one or two times per capita GDP, but the limit may be set with more precision by examining the distribution of deposits by size. Within this distribution, the limit should be set to cover the majority of the total number of deposits (say, 80 to 90 percent of the number of deposits), but only a smaller percentage of the total value of deposits (say, 20 percent of the value of all deposits).20 Each country should conduct a careful assessment of the level of coverage that will strike a balance between discouraging destabilizing runs by small depositors while retaining market discipline from larger depositors. The country may also set its coverage level with a view to maintaining the international competitiveness of its banks.

As shown in Figure 1, the limits to the full coverage that countries provide vary widely—from more than eight times per capita GDP in Oman to less than the level of per capita GDP in some Central and Eastern European countries. If a depositor’s holdings exceed the amount covered under the system, the depositor will take a place in line with other creditors to receive the proceeds recovered over time from the assets of the failed bank. Alternatively, as in a number of countries, there could be coinsurance above the basic coverage.

Figure I.
Figure I.

Ratios of Deposit Coverage to per capita GDP in Selected Countries, 2000

Source: GDP per capita for 1999, World Economic Outlook.1Weighted by total deposits, IFS.2Coverage for Germany refers only to that under the public, mandatory system3Coverage in Chile is for savings and time deposits.

Coinsurance

To encourage market discipline, some countries require all depositors to bear risk on all of their deposits. Coinsurance has the advantage of assuring depositors of the prompt repayment of at least part of their deposit. It is often run on a sliding scale, so that depositors recover, say, 90 percent of a small tranche of their deposit, a smaller percentage of the second tranche, and successively smaller percentages of the subsequent tranches. This practice is not optimal, however, because it fails to provide basic consumer protection and therefore does little to prevent small depositors from triggering a run. A more acceptable system is to cover the smallest tranche of deposits in full and impose a haircut on larger deposits.21 Above-the-limit coinsurance will increase total coverage somewhat. This type of coinsurance may encourage savings, but has two disadvantages. First, it is more difficult for the public to understand and, second, it may increase the cost of resolving failed banks. Consequently, a country may want to carefully consider the relative costs and benefits of installing more than two tranches. The advantage that coinsurance provides—quick access to larger depositors’ funds—can also be obtained if a deposit insurer with a broad mandate provides uninsured depositors with an advance payment to uninsured depositors of part of what the system estimates it will recover from the failed banks’ assets.

Should the Coverage Limit Be Indexed to Inflation?

Although some countries index the coverage limit for inflation, good practice argues against indexing, as this leads to annual changes that would be difficult for depositors to remember. Being able to keep track of the coverage limit is essential for enabling the public to protect its interests. The ideal situation is one where a country has low inflation, so that it can keep the limit constant for a relatively long period of time until the increasing value of real GDP warrants an increase. In this way. the public can know the coverage limit with certainty and the limit remains appropriate to the number and value of deposits in the economy. When adjustments are necessary, however, it may be better to delay changing the coverage limit, until an easy-to-remember number becomes appropriate.

Netting Deposits Against Loans

It is sometimes suggested that the receiver or liquidator of a failed bank, rather than paying a depositor directly in full, should offset (i.e., net or set off) deposits against any obligations the depositor has to the bank (see Box 2).22 Offsetting loans that are in default is appropriate, but offsetting loans that are current could destroy a healthy business that may, for example, be unable to find a quick replacement for its working capital. Thus, the approach that is recommended below has been adopted in a number of countries in order to find a balance between two considerations.

Offsetting Loans Against Deposits

Two fundamental questions arise regarding offsetting.

One question asks whether netting should apply regardless of the status of the loan or whether it should occur only when the loan is due or in default. Netting against performing loans could prejudice the viability of sound businesses whose loans, in effect, are called and are thus simultaneously deprived of their liquid assets. Consequently, netting is almost universally confined to cases where the loan has matured or is in default.1

Another question relates to the status of the deposit. When legal bankruptcy occurs, all claims become due and payable immediately. However, a liquidator or receiver might not want to pay out the full amount of the principal and accrued interest on a long-term deposit that carries a below market rate. He would prefer to offer the lower, net present value of the deposit, which would conserve deposit insurance resources. But he can do so only if there is a special provision in the law permitting him to do so.

There are opposing views on netting and country practices diverge in applying the concept.

One view, typically taken in countries in the Anglo-American tradition, stresses that it is important to protect the creditors of the failed bank by maximizing the amount recovered from its assets and so favors offsetting matured mutual claims. They argue that it is unjust that a defaulting borrower should insist on payment of his deposit but not service his loan, that netting protects creditors and reduces the transmission of failure from one bank to another, reduces litigation and, thus, the cost of credit, and prevents the bank’s borrower from being bankrupted unnecessarily when he has funds already available. (Countries favoring this view are listed in the first column of Table 4 of Garcia, 1996.)

The other view, espoused in Franco-Latin countries, considers that offsetting departs from the principle of equal treatment of creditors. In general, the authorities in these countries also consider that netting is inequitable to debtors and so they prohibit it when insolvency occurs because the creditor gets paid in full (up to the amount of the deposit), but the depositor may receive only a portion of his funds. (For countries opposing this view, see the second column of Table 4 in Garcia, 1996).

However, there is also an issue concerning netting in relation to deposit insurance. It should be noted that offsetting also gives borrowers a priority over the assets of the failed bank as compared to other depositors because it grants, in effect, a speedy and 100 percent coverage of the deposit that is offset against a loan. Other depositors have to stand in line to obtain the more limited coverage available under the deposit insurance system or from the proceeds obtained when the bank is liquidated. It would, for example, be possible for a depositor who is concerned about the condition of his bank to take out a loan immediately before the bank is closed and so obtain full and speedy coverage for his deposit. However, a more telling argument is that, by offsetting unpaid obligations against insured deposits, the liquidator or receiver can reduce the cost of the payoff to the deposit insurance system.

Finally, netting becomes more complex where the deposit insurer and the liquidator/receiver of the failed bank are separate entities than where there is no deposit insurance system or the system is also the receiver (as in the United States). With separate agencies, the deposit insurance system compensates insured depositors, and seeks recompense from the liquidator/receiver who takes ownership of the bank’s assets and uses the proceeds from their liquidation to repay the deposit insurer, uninsured depositors, and other creditors.2 Then, special agreements have to be formalized to make netting feasible.

1 See, for example, Sections 53–55 of the Bankruptcy Code of the Netherlands. However, some countries (e.g., Peru) net all types of deposits against loans regardless of status.2 Each country’s law will determine the priority of claims among these groups. Such priorities are discussed further in Garcia (1996, pp. 39–41 and Appendix 1).

The first consideration is providing incentives for borrowers to service their loans now and in the future, and for depositors and other bank creditors to continue to trust the banking system. The second consideration is minimizing costs to the deposit insurer.

When a depositor is also a debtor of the failed bank, his/her deposit should be netted (offset) against the loan, but only if it is overdue or delinquent. It would be unfair to other depositors if the holder of a delinquent loan, especially one that has contributed to the failure of the bank, were to benefit from insurance coverage. Hence, the balance of the defaulter’s deposit should be netted (offset) against his overdue loan(s). Loans that are current, however, should not be offset against a borrower’s deposits. To do so could unfairly deprive a good borrower of working capital and prejudice his ability to continue in business. Accordingly, this paper recommends that the insured parts of deposits of all kinds be netted against:

  • claims that have already fallen due or are delinquent;

  • promised, but undelivered, subscriptions from shareholders; and

  • damage assessments against owners and managers.23

Offsetting would also be restricted to situations where both the bank’s and the customer’s claims are well-documented, can be settled easily, are not subject to dispute, and were established well before the bank became insolvent.24 If the value of the loan exceeds that of the deposits, the remainder of the loan would continue to exist as a claim against the debtor.

These recommended principles would need to be firmly established in the insolvency law of the country, perhaps as an administrative-law exception to the general bankruptcy law that would govern bank failures and depositor protection. For example, the governing law or contract would lay down the basic-process for determining who gels what, and in what order. It is recognized that it may prove difficult to graft these principles on to some legal frameworks.

Reducing Adverse Selection

There are two design features for the system of deposit insurance that will help to reduce the incidence of adverse selection, which occurs when the weakest institutions choose to join a voluntary system, while the strongest remain outside. Such a system is unlikely to remain financially viable. First, membership should be compulsory. In particular, the system should not allow members to leave the system when they choose to do so, and they certainly should not receive a refund of their accumulated contributions. Second, when a deposit insurer has gained experience, it may institute a system of risk-adjusted premiums to reward stronger banks within the compulsory system.

Make Membership Compulsory

Membership in the system should be mandatory for all institutions located in the country, including specialized state-owned banks that accept deposits and are supervised by the supervisory authority. Otherwise, only the weakest institutions will join and the system will not be financially viable. Membership should be broad because the cost of the insurance must be shared among a wide number of institutions, if the scheme is to remain financially viable. Although compulsory membership involves a degree of cross-subsidization by strong institutions of weak ones, all members, even the strongest ones, benefit from having a more stable industry with reduced fear of depositor runs. The stronger institutions should be required to pay for that privilege.

Include State-Owned Institutions

The playing field needs to be level for all deposit-taking institutions to encourage competition. Thus, government-owned institutions that take deposits should also be required to join the deposit insurance system and pay premiums at the same rate as other members, even if they are initially the beneficiaries of an implicit full government guarantee that the government plans to phase out later. Government-owned institutions should also be supervised to the same standards as other insurance participants and ultimately receive the same coverage as private institutions. Thus, a country’s banking act might need to be revised to bring the regulation and supervision of state-owned institutions under the supervisory authority. Finally, at an opportune moment, as discussed further in Section III, the full implicit or explicit guarantee for state-owned institutions should be removed.

Institutional Membership: Inclusions and Exclusions

Membership should be compulsory for all eligible members. These would include:

  • All domestic banks and other deposit-taking institutions explicitly encompassed by the system of deposit insurance according to the law.

  • All branches and subsidiaries of foreign banks operating onshore. Foreign institutions should regard paying insurance premiums as a cost of doing business in a country. Sometimes the deposits of a foreign bank are covered under banks’ domestic insurance system. The host country can supplement the coverage offered abroad where that coverage is for a smaller amount and it can accept foreign coverage if the amount insured is larger. Doing the latter, however, may give foreign banks an advantage in the domestic market.25

  • Finance companies, credit unions, and cooperatives would join the system as long as they faced the same prudential regulations and were supervised by the same agency as banks and other insured depository institutions. Allowing institutions that are not strictly supervised to join would not be fair to those members that face stringent regulations, as the more loosely supervised firms are more likely to impose losses on the fund. The government, however, may consider establishing separate deposit insurance schemes for credit unions and cooperatives (possibly with lower coverage limits).

Some countries consider that the purpose of the deposit insurance scheme is to protect the deposits of residents: consequently, they exclude nonresidents, Systems in other countries cover nonresidents, however, to encourage deposits from nonresidents.

When considering the treatment of nonresidents and foreign institutions, the following good practice applies:

  • Banks operating offshore would be excluded. The exclusion would cover foreign branches and subsidiaries and units of domestic banks that operate offshore. The objective of the insurance scheme is to protect domestic residents from loss, not foreign residents. In nondollarized economies, this aim would be achieved by covering only domestic currency deposits.

Risk-Adjusting Premiums

A system of risk-based premiums is logically satisfying, but it is not easy to administer. Nevertheless, as the survey in Section III shows, more than one-third of countries with explicit deposit insurance schemes is currently using systems of risk-based premiums.26. This is a recent development and contrasts with the findings of Kyei (1995).

The objective of risk-adjusting premiums is to require riskier institutions that are more likely to call upon assistance from the deposit insurer to pay more for coverage. Yet insurance always contains an element of cross-subsidization of the weakest members by the strongest. The principles of actuarial accuracy and cross-subsidization are both desirable up to a point, but they conflict. Thus, a balance has to be struck, as in all insurance contracts, between the two principles. Moreover, there is a second conflict. Setting the premiums to reflect the risk an institution poses to the fund can be complex. Yet, there are advantages to having a system that is easy for the consumer and the markets to understand. Choosing an appropriate balance between actuarial accuracy and simplicity is a challenge.

As a result, the architects of a newly created deposit insurance system are advised to “keep it simple” until they have gained experience in implementing the system. Simplicity may involve charging uniform premiums until system staff become experienced enough to tackle the complex task of adjusting deposit insurance premiums for risk.

Techniques for Risk-Adjustment

Nevertheless, countries that have had systems in place for some time are now moving toward risk-adjustment. In the process they have adopted a number of approaches to adjusting the premiums that banks pay to reflect the risk they impose on the system. One straightforward method is to ask banks to pay premiums based on their risk-adjusted assets, rather than on their deposits. This approach imposes no additional costs of calculation on banks and might be a good starting point for a country wanting to move away from premiums set uniformly on deposits in all banks. While the current system of risk-adjustment for assets under the Basel Capital Accord is crude, it is in the process of being refined.

A second approach is to charge lower premiums to banks that have higher capital ratios and/or supervisory ratings. The FDIC in the United States takes both capital and CAMELS ratings into account.27 Other countries use more complex systems for assessing risk.28 These ratings are typically not disclosed to the public on an individualbank basis.

Minimizing Agency Problems

A deposit insurance scheme may be privately, publicly, or jointly funded and operated. In any of these arrangements, problems (called “agency problems”) can occur when an agent serves his own interests rather than those of the principal who employs him. These principal—agent relationships can be complex in deposit insurance systems and give rise to three kinds of agency problems—political interference, regulatory capture, and interagency conflicts. In turn, this problem can result in high fiscal costs.

In the case of deposit insurance, some consideration has to be given to identifying who is the agent and who is the principal. Whether the deposit insurance agency is publicly or privately run the agency, acting to protect the interests of depositors, is the agent. In a privately run system, the banks are the principals because they both fund and govern the system. (The system should be funded by the member banks themselves to limit government outlays and provide peer pressure for safety.) In a privately funded scheme that has government financial backing, however, the government may or may not run the scheme. When the government runs a privately funded scheme, it, acting on behalf of taxpayers, and the banks are both principals. The deposit insurance system is still the agent that acts for the depositors.

Government backing tends to bolster a system’s credibility. Hence it is no surprise that government backing is provided for all but the strongest banking systems. The overriding argument in favor of a government-run scheme is financial integrity. To limit conflicts of interest, a system with public backing is best run by a government agency. A second best solution is to have a system jointly operated by the government and the banks, but where bankers do not dominate the board of directors.29 Allowance can be made for input from the banking industry through an advisory committee to the board.

If publicly or jointly run, the agency can be integral with, or separate from, the central bank and the supervisory agency. In either case, conflicts between the interests of the monetary authority, the banking supervisor, and the deposit insurer can occur both within departments of the same agency and across separate agencies. In addition, the deposit protection system can become captured by the industry, and interagency conflicts may occur, but these problems can occur also in a privately run scheme.

Political Interference

The first agency problem, which applies particularly to a government-run scheme, is interference by politicians in the operations of banks, in their supervision, and/or in the insurance function. This problem can be contained by sanctioning interference and by making the agency an independent organization that is nevertheless accountable to the government and/or the legislature for its actions, operations, and administration. The agency needs to be supported by a clear legal and regulatory framework to limit political interference. Prohibiting, limiting, and/or publicly disclosing financial contributions to campaign funds for elected officials, especially those with responsibilities for overseeing financial agencies, will help to contain political interference. Transparency in its operations also helps because it allows the press to report untoward actions and the public to scrutinize the system in order to protect its position as bank customer and/or taxpayer.

Regulatory Capture

The second agency problem is regulatory capture—a situation where the deposit insurance agency serves the banks, rather than the interests of the public at large as depositors and taxpayers. In a privately run and funded scheme, bankers are appropriately in charge, so the problem arises only when a privately funded scheme has government financial backing. The danger of capture can be reduced by having the government run the scheme even though it is “owned” by the banks, by not allowing bankers to dominate the agency’s board of directors, and by taking other steps to keep agency officials focused on their public responsibilities.

Bankers have useful perspectives on the banking situation and need a forum for expressing their interests regarding deposit insurance, so they may form a consultative committee to the board of directors of the deposit guarantee system. The system’s managers and staff should be trained to keep their public responsibilities in mind when executing their duties. Having to report publicly to the administration and the legislature will give the public an opportunity to assess the system’s performance of its public trust. Staff may be precluded from accepting honoraria or from taking positions at member institutions for a number of years after they leave the agency.

Interagency Friction

The third agency problem is a lack of cooperation between or within financial regulatory agencies. On occasion, there can be disputes leading to hostility. This situation can occur, for example, where the deposit insurer depends on the supervisor for information about institutions in the system, and on the central bank for macroeconomic insights, but where the supervisor and the monetary authority are unable or unwilling to provide necessary information.

To help remedy this problem, the objectives and functions of different financial authorities must be clarified. The functions include monetary policy, supervision, deposit insurance, bank restructuring, and fiscal policy. Such clarity of purpose is more important than the institutional location, which often is determined by the availability of scarce banking skills, human constraints, short-term legal impediments, etc. Especially in a small country with a shortage of skilled personnel, the central bank, as the monetary authority, may also be responsible for bank supervision and deposit insurance.30 Where resources are greater, there is much to be said for keeping the responsibility for deposit insurance separate from the supervisory authority and the central bank. A ministry of finance could be involved because of its responsibility for systemic bank restructuring, but the preference is to have the deposit insurer not report to the ministry. Regardless of their institutional location, there would need to be close cooperation between these different authorities.

If separate, the deposit insurance agency needs to consult with the other agencies to assure that it has adequate information. It is uneconomical for the system to establish a duplicate structure for banking supervision. The consultation may be facilitated by including members of the other agencies on the system’s board. In a public or quasi-public system, the board of directors should not be dominated by bankers, who, as mentioned earlier, have a conflict of interest and may try to transfer costs from banks to the government. In a private system of deposit insurance, the board of directors should include a representative from the bank supervisory agency.

Collaboration and Information Sharing with the Supervisor

If the deposit insurance agency is to carry out its responsibilities successfully, it must be assured of access to necessary information and cooperation from the supervisory and other government authorities.

  • The paybox deposit insurance agency, whether public or private, must receive from the supervisor the names and addresses of the depositors that are to be compensated and the amounts due to them.

A broad deposit insurance agency will also need data on bank conditions. Where the agency is run by the government, communication problems can be reduced by placing a legal obligation on the supervisor and the central bank to provide the necessary information. The deposit insurer, the central bank, and the supervisory agency can also be required to cooperate closely. However, where the broad agency is purely private, the problem is more difficult to resolve. The supervisor would be appropriately reluctant to divulge data on bank conditions that would give a competitive advantage to those banks that provide board members to the agency. However, for a publicly run deposit insurance system:

  • The legislation should require a smooth flow of information and close cooperation among the deposit insurance agency, the supervisor, central bank, and the ministry of finance. What information will be shared, and under what circumstances, needs to be carefully studied and agreed upon. This includes the extern to which the supervisor should be required to provide examination and other supervisory reports to the agency. To enable the quick resolution of a failed entity, the deposit insurer must receive information from the supervisor at an early stage to make necessary preparations.

  • As discussed above, the broad deposit insurance agency should be able to request the supervisor to undertake a special examination of any insured financial institution that it feels may be in financial difficulties. Whether agency staff should be able to participate in onsite inspections would vary from country to country.

The deposit insurance authority would have no supervisory responsibilities beyond the right to receive information from the supervisor and request special onsite examinations. In some countries, it could be required to report to a government agency, such as the ministry of finance, in cases where it has concerns over a bank’s condition, but where the supervisor fails to take action.

Relations with the Lender of Last Resort

It is the role of the lender of last resort, not the deposit insurer, to lend to solvent but illiquid banks, and to sterilize that lending where it is necessary to keep within appropriate limits for reserve money growth, to discourage runs against them by uninsured depositors. The insurer’s role is to compensate depositors. The insurer with a broad mandate will also deal with insolvent, nonviable banks and resolve them in a cost-effective and incentive-compatible manner. However, there can also be a conflict of interest between the broad system of deposit insurance and the lender of last resort. The latter organization may be unduly willing (especially where its support is covered by high-quality collateral) to provide lender-of-last-resort assistance to troubled banks, which will delay closure and increase the costs for the insurance system.31 To reduce this problem, both the deposit insurance and central bank laws may need to be written to ensure a consistent legal framework that facilitates close cooperation between the insurance system and the lender of last resort/central bank.

The problem of excessive lender-of-last-resort lending arises partly because it is difficult to distinguish between illiquidity and insolvency. Because a lender of last resort that lends to insolvent banks causes moral hazard, raises insurance costs, and reduces monetary control, lender-of-last-resort accommodation should be fully collateralized by sound assets that would be acceptable in the private markets in normal times. But, as argued earlier, even collateralized lender-of-last-resort lending to insolvent banks should be discouraged because it prolongs the life of such banks and crowds out other creditors. However, exceptions may be made to the application of this principle in certain circumstances. For example, a central bank might provide “bridging liquidity assistance” for a short period to a bank that has just been found to be insolvent, while a resolution is sought for it. As a precaution against moral hazard, control of the bank might be taken from its owners while it awaits recapitalization, sale, or closure.

Promoting Credibility

The design of the deposit insurance agency can importantly influence its credibility.32 Apart from the agency’s role, which was discussed previously, the agency should be designed to be independent but accountable and have adequate management and staffing.

Design and Organization of a Deposit Insurance Agency

A government-financed system needs to be run by an agency with adequate authority and political independence. At the same time, the agency must be accountable for its actions, so that it does not act in an arbitrary and capricious manner. The recommendations in this section seek to provide the requisite authority, independence, and accountability.

Authority

A “paybox” may be privately run, but to ensure sufficient authority the agency with a broad mandate needs to be a government agency established by law.33 For example, to maintain public confidence, the broad deposit insurance system must have government backing. In addition, the supervisor or agency will have a strong powers to deal in a strict manner with nonviable banks, terminate the interests of shareholders, and impose “haircuts” on uninsured depositors and unsecured creditors. Power to do so should be granted by law, and such responsibilities can only be exercised by a government agency. To fulfill its responsibilities, the agency will need adequate financial resources as discussed later in this section, as well as access to information as discussed earlier.

Independence

Independence is typically not a problem in a privately run deposit insurance agency, but a number of steps need to be taken to ensure independence for a government-run agency. In this context, independence refers to status within the government and to freedom from political pressure and domination by the banking industry. In a large country that has a pool of workers with sufficient financial skills, the deposit insurance agency should be separated from the central bank and the supervisory authority, since the monetary authority, the supervisor, and the agency have different, although complementary, responsibilities. In smaller countries, the central bank may have separate departments to cover monetary policy, bank supervision, and deposit insurance. Allowing these institutions to pursue separate, sometimes conflicting, objectives, while still cooperating, is a challenge.

The following best practices apply:

  • Ideally, the deposit insurance authority should be separate from the supervisory and monetary authority. The supervisor and the agency have different, although complementary, responsibilities. There could be a number of conflicts of interests in normal times if all responsibilities resided with the central bank. Nevertheless, these three institutions need to cooperate, especially in times of financial stress.

  • The agency should be independent of political influence. At times, the agency may need to take actions that are unpopular with certain domestic or foreign interest groups. To act according to the law in a fair and evenhanded way, agency staff must, therefore, be free from political pressure that can cause certain individuals, companies, or economic sectors to win exceptions from laws and regulations—otherwise known as “forbearance.” Independence has particular consequences for the composition of the board of directors.

  • The board of directors of a government-run deposit guarantee system should reflect its independent status. It should consist of either five or seven members, appointed for staggered terms of, say, four years. The board’s size should not be unwieldy and should not be so large as to allow individual members to hide among a multitude of members. An odd number of members is needed to make securing a majority easier. Members will have security of tenure for their limited term in office, to facilitate their independence from political interference. Board members should he relieved of their positions only for gross misconduct defined in the law (using comparable standards in other of the country’s laws) to avoid dismissing them for political or petty reasons. Terms in office should be staggered to provide continuity in membership and to allow experience gained not to be lost all at once.

  • The board members of a government-run deposit insurance agency should he nominated by the government (the administration) and confirmed by the legislature where there is a “separation of powers:” otherwise the board members should be confirmed by the cabinet. In this way, the government would be responsible for the integrity and effectiveness of the board, and the avenue for the agency’s accountability through the government to the public would be established.

  • When it backs the deposit insurance fund, the government should be able to appoint board members who would have a fiduciary interest in protecting the public. Such members would serve the public interest and not focus on the particular concerns of the banking industry, sectoral interests, or politicians’ preferences.

  • The board of a government-run deposit insurance system should have two ex-officio members. One would represent the supervisor (the agency head or his designated representative), and one the ministry of finance (the minister or his designated representative). The government needs to be represented on the board, but should not dominate it by having a majority of the membership or the position of chairman. As the government will guarantee the system and bear the costs of any failures, the ministry of finance must be represented on the authority’s board. The monetary authority might, but does not have to be, represented on the board.

  • The remainder of the board, constituting the majority, should be drawn from outside the government. This provision serves to protect the political independence of the deposit insurance authority, and also to draw on the necessary expertise. One of these outside members should be appointed chairman.

  • There should be no board members who are currently employed by financial institutions that are members of the deposit insurance system on a government-run deposit insurance agency.34 Likewise, major shareholders of insured institutions, and other individuals with close family or financial linkages (to be defined in the banking law) with them, should not be board members. For example, the agency will have access to information about the condition of individual member institutions. It would be inappropriate to give this information to a board member who is an employee, major shareholder, or closely linked with another insured institution. This provision prevents institutions “connected” with a board member from receiving information that would give them an advantage over competitors. Moreover, bankers might suffer from a conflict of interest and try to underfund the authority, so that the government would be forced to cover additional costs. However, bankers’ experience and perspectives will be valuable to the deposit insurance agency. Consequently, a consultative council of bankers should be formed to advise the authority and bring members’ concerns to the attention of the board.

  • Other qualifications could be specified in the deposit insurance law. For example, the law might specify that board members and senior officials should be “fit and proper.” have relevant education and/or experience, and other characteristics deemed desirable.

  • The law also should grant board members immunities and protection against lawsuits for official acts taken in the course of their duties.

In small countries with limited financial expertise, however, the public deposit insurer may be a separate department of the central bank, which may also contain the supervisory agency. The central bank may have difficulty in separating its responsibilities as guardian of monetary policy and lender of last resort from those of supervising banks and running the system of deposit insurance, even if lodged in a separate department. Moreover, the objectives of the three entities may conflict. For example, by relying on its priority as a collateralized lender over the assets of the failed bank, the last resort lender may be too ready to provide liquidity assistance to a troubled bank because it is sure of getting its money back. But in being overly willing to provide liquidity assistance to prevent the bank from failing, it frequently imposes additional losses on the deposit insurer and uninsured creditors.35 But where it is less assured of being made whole, it may be unwilling to provide needed liquidity assistance even when appropriate. Similarly, the responsibilities of the supervisor or the ministry of finance may sometimes conflict with those of the deposit insurance system, so there can be advantages to housing them in separate agencies.

Accountability

A privately run and completely privately funded deposit insurance system is responsible to its member banks. While the government-run deposit insurance agency must be free from political interference and industry domination, it must be held accountable to the government, the public, and the banking industry for its decisions and actions. Otherwise, there is a greater risk that it would act in an arbitrary, capricious, or ineffectual manner. The path of accountability will differ depending on the political structure of the country and may well differ in a parliamentary system from a country that practices the separation of powers. Recommendations for facilitating accountability in a parliamentary system follow:

  • The accountability of a government-run deposit insurance agency should be to the administration and to the legislature. Because the ministry of finance must ultimately meet the cost of any financial inadequacy in the authority fund, the agency might first be accountable to the ministry of finance. Through the ministry, the agency will be accountable to the cabinet, parliament, and, ultimately, to the public. The press will have an important role to play in keeping the public informed.

  • The deposit insurance authority should be fiscally responsible, have financial integrity, and provide the public and the banking industry with a means of monitoring its performance. The authority must maintain its books and records in a transparent way and be subject to the same audit rules as other public entities. The records of a public deposit insurance agency must, therefore, be subject to a published annual audit conducted by the Office of the Auditor General or its equivalent.

Striking a Balance Between Independence and Accountability

Special arrangements are needed to strike an appropriate balance between independence and accountability. This can be achieved in a privately financed and privately run corporation by having bankers dominate the deposit insurance system’s board. The board could be elected by the shareholders so as to represent all segments of the insured industry and not just the largest members. This should help to make the system politically independent (as long as it is financially sound and does not need to request financial support from the government). Having members elect the board for a fixed term of office, and having the board report to the members in an annual report and shareholders’ meeting, encourages accountability.

Achieving the right balance is more problematic in a scheme that has government financial support and is run by a government agency/corporation. Political interference can be discouraged by making the deposit insurer a department of either the central bank or the supervisory agency, where the host has a constitution that grants it independence and a reputation supports it. But this arrangement can present conflicts of interest within the central bank or supervisory host. A number of countries prefer, therefore, to have a system that is separate from both the central bank and the supervisory agency. To gain independence it will need an appropriate implementing statute: adequate sources of private funding with legislated back-up funding that does not require parliamentary approval; fixed terms of office for members of the board who should be removed only for good and specified causes; clear criteria for eligibility for membership of the board;36 an appointment process that features public hearings and legislative approval of the government nominee: and direct reporting of the deposit insurance system to parliament rather than to a government ministry.37 In addition, an active and inquisitive press will facilitate accountability.

Staffing

The proposed deposit insurance agency could have a small staff in a country where there is not a large number of insured institutions and failures are rare. It can, in addition, delegate responsibilities to the central bank or the supervisory authority when necessary. Where the authority has a broad mandate, it could subcontract liquidations to private liquidators or financial institutions. Staff would need to be augmented in times of stress on the banking system by borrowing from the central bank or supervisor that had qualified personnel. Under the deposit insurance law, the staff (as well as the board) of the government-run authority must be granted legal protection in the form of immunities and protection against lawsuits for any actions they take in the course of their duties, and that are in accordance with the law. Staff would, of course, need analytical skills and high integrity.

Infrastructure

To support a system of deposit insurance, appropriate laws and an effective judicial system must be in place, so that property rights can be protected when needed. In addition, systems of accounting and auditing need to meet international standards to facilitate the accurate valuation of banks’ portfolios. A broadly based financial system that includes, for example, insurance companies, will strengthen the banking system by allowing it to diversify its portfolios.

Public Relations

A good program of public relations will help maintain the credibility of the system of deposit protection. Such a program requires that the deposit insurer issue pamphlets and publications that keep the public informed about coverage under the guarantee. The public needs to know the monetary limits on coverage. These issues are easier for the public to understand and remember if they do not change frequently. The authority must also ensure that member institutions provide information on coverage to customers and potential customers. This will be easier if the deposit insurance system has its own logo, which members can display. The authority must also prevent nonmembers from masquerading as insured under the system.

Ensuring Financial Integrity

A number of financial issues need to be resolved before setting up a system: when to initiate the system of deposit insurance: whether to fund the system by ex ante premiums or ex post assessments on member institutions; where to set the target level for the fund; who should pay the start-up assessments: how to set the structure for premiums, provide back-up funding, and manage fund assets: and what should be the order of priority over the assets of a failed bank. Resolving these issues effectively will improve the financial position of the system and reduce its need to call on government resources for backup.

As mentioned previously, a deposit insurance system should be initiated when the banking system is sound. To do otherwise is to risk placing excessive demands on the fund before it has accumulated sufficient reserves; in such a case a crisis might drain the fund’s coffers and result in its insolvency.38

To Fund Ex Ante or Ex Post?

Deposit insurance outlays can be met either from a fund that has been accumulated from system premiums paid in the past or by imposing an ex post levy assessed on surviving banks. In principle and in practice, it is possible to both accumulate a fund and to impose an additional levy ex post, if the fund proves to be insufficient. In fact, more countries have opted to build a fund ex ante, rather than to levy an ex post assessment (sec Table A4 of the Statistical Appendix) and a number do “top up” their fund with additional ex post assessments, when the fund comes under financial pressure.39 In either case, making it clear that the responsibility for covering the insured deposits of failed banks falls on banks, not the government, encourages banks to restrain their risk-prone peers, and thus reduces outlays by the system.

With regard to funding, it is recommended that:

  • An insurance fund should be established. Most countries that have recently adopted a system of deposit insurance have established such a fund. An appropriate fund increases the flexibility to deal with banking problems and, thus, enhances public confidence in the deposit insurance and the banking systems.

  • A country should choose a target level for its fund sufficient to cover outlays under normal circumstances. The target is often set as a percentage of insured deposits at a level that would enable the fund to cover insured depositors in a number of small banks, or say, two medium-sized banks or one large bank. It may need to be acknowledged that it would be too costly to maintain a fund at a level to enable a payout of all the deposits of the largest banks. 40 The deposit insurance agency would only be able to deal with problems in individual banks. In the case of a systemic crisis, the government would probably need to override the agency framework and adopt more comprehensive measures (see, for example. Enoch, Garcia, and Sundararajan. 1999).

Optimum Fund Size

Providing an analytical basis for determining the optimum size of a deposit insurance fund in any country is a subject where additional research is needed. There are two separate philosophies regarding fund size. One aims to have a fund large enough to self-sufficiently compensate depositors immediately when bank failures occur in normal times. The second philosophy is to reduce fund size, but only to a level that enables the system to borrow to pay depositors in failed banks. The system will then repay the borrowings over time. The second approach verges on ex post funding. The United States maintain a large fund; Canada a smaller fund.

Start-Up Funding

A newly established system may receive initial contributions from banks, the government, and/or the central bank (Table A4 of the Statistical Appendix). Where banks are strong enough initially to foot the bill, they should do so. But this is often not the case.

Whatever its source:

  • Initial funding should be set at a level sufficient to make the scheme credible and operational. As the scheme will ideally be introduced only when the banking system is sound, the scheme should not have to handle any failures upon its introduction. Nevertheless, the initial contribution should be sufficient to enable the fund to reach its full target capitalization as quickly as possible.

  • If the government provides initial funding, provision can be made for the deposit insurance fund or banks to repay the government’s contribution over time.

Ongoing Funding—Premiums

Going forward, an insurance fund would be accumulated and members would be required to pay premiums quarterly or semiannually at the rate of “x” percent per year based on total deposits. The premiums would be levied as needed to cover expenses and build, maintain, or rebuild the fund to its target level. Thus, premiums will vary from country to country and from time to time. Levying premiums on all kinds of deposits (insured and uninsured) is easier to administer, and it provides a broader contribution base, although many countries find it more equitable to levy charges against only the total value of deposits held in insurable instruments, or to go further toward equity and levy only against the value of those deposits that are actually covered (for country practices in this regard, see Table A4 of the Statistical Appendix).

When setting premiums, policymakers should keep the following in mind:

  • Regular premiums or contributions should be set by the deposit insurance agency as a percentage of total, insurable, or insured deposits. An argument can be made that premiums should be assessed on all deposits, because all depositors, whether insured or not, benefit from the system of deposit insurance. A number of countries, however, believe that fairness is enhanced by confining assessment to insured deposits—that is, those who benefit most directly.

  • Premiums could be paid directly to the deposit insurance agency or they could be automatically deducted by the central bank from the reserve accounts of members and passed to the system.

  • Premium levels will vary with the deposit base. The broader the base, the lower is the premium necessary to achieve a chosen income level. The premium could be determined by the deposit insurance agency, but should not exceed a legally set rate that would impose an undue burden on covered institutions.

  • The agency’s board would have the discretion to reduce premiums but only after the target level for the fund is reached, and after the initial contribution by the government has been repaid. The premium reduction should be made in a way that maintains the fund at its larger level

  • The board should have the right to levy additional premiums if the fund has been depleted. These premiums would continue until the fund is restored to desired levels.

  • Bankers should be encouraged when they recognize that premiums will be reduced once the fund reaches its target. They would then have incentives to support early intervention by supervisors in problem banks to limit future claims on the fund.

  • Risk-based premiums are fairer in principle and should reward sound institutions. Premiums should be set at a uniform (flat) rate, however, until the supervisory system is in a good position to differentiate among risk profiles. Otherwise, bankers will contest those assessments they perceive to be unfair. Once the supervisors have honed their monitoring and assessment capabilities, a system of risk-based premiums can be introduced, preferably one that reduces the premium for exceptionally strong banks, while raising it for risky institutions.

  • Premiums would be accounted for as an expense and thus would be tax deductible. They would not he counted as an asset of the contributing institution. Paying premiums would be the legal obligation of each institution, and a cost of doing banking business in the country. As such, the expense should be tax-deductible.

Controlling Outlays

To preserve fund levels and keep premiums low, the insurer needs to restrict its outlays through efficient operations, maximize recoveries from the disposition of the assets of failed banks, limit its obligations in various ways, and make wise investments. Dealing with troubled banks promptly and firmly reduces outlays.

Depositor Preference

Giving depositors and/or the insurance fund preference over the assets of the failed bank increases their share in the value recovered and reduces the fund’s net outlays, while increasing the share of the losses borne by others (Garcia 1996. Appendix I).

In the absence of deposit insurance, the treatment of depositors, creditors, and other claimants when a bank fails is determined by the priorities that the law establishes among claimants over the assets of the bank in liquidation. Deposit insurance, in effect, satisfies small depositors’ claims first. It must therefore be determined where the deposit insurer itself stands within the hierarchy of claimants.

One way to protect the resources of the deposit insurance system is to give depositors, or the system itself, priority over the claims on the assets of the insured tailed bank. Such priority has an advantage in that it increases the amount the system is likely to recover from the failed bank’s assets, and so reduces financial demands on the accumulated fund. The more the system recovers, the less it has to call on its accumulated resources or levy its members. But priority also has a major disadvantage where the insurer is the receiver/liquidator of the failed bank. It then has less, or no, incentive to maximize the total value of recovered assets, especially in cases where it has a legal priority. If depositors, insured depositors, or the system itself are reimbursed ahead of other claimants, they will receive a higher proportion on all of their claims than they would, absent such priority. Granting priority conserves fund resources, but it does so at the expense of other claimants and it may reduce the care that the deposit insurance system executes when it liquidates or otherwise disposes of the assets of the failed bank.

The choice between granting priority and not granting it (i.e., having the deposit insurer, succeeding to the rights of the insured depositors, with the same priority over the assets of a failed institution as large depositors, and ranking equally with general (unsecured) creditors) is a judgment call. The choice would be influenced by an assessment of the balance between a fiscal need and deposit insurance system efficiency in recoveries. This recommendation would need to be coordinated with the priorities established in new Banking and Bankruptcy Laws.

Managing Fund Assets

Another defense of the fund is to invest fund resources wisely, preferably in safe assets. As even government paper may not always be sufficiently liquid in a small volatile economy, the deposit insurance system may wish to invest in government securities abroad. It should not place deposits in troubled banks.41

When investing fund resources:

  • The deposit insurance agency fund should be invested in government securities. The agency should not be allowed to invest in risky securities or investments that might cause a loss. Funds should not be placed as deposits in insured institutions. The insurance fund should earn market interest on the funds it has accumulated and carefully consider its needs for liquidity. Government securities are an appropriate investment and safe haven for the agency fund. The agency should determine the most appropriate maturity for those securities, for example, the securities could he long-term because longer maturities would typically pay higher interest rates. Safety, however, is of greater importance than yield. The fund should be able to discount its government securities at the central bank to gel liquidity when needed. Investing in (sound) foreign government securities may diversify the portfolio, protect against foreign exchange losses, and against credit risk if the financial position of the domestic government is weak.

Back-Up Funding

Despite the efforts to build a fund and control expenses, in times of stress, the accumulated fund may prove insufficient to meet the demands placed upon it. For example, unexpected failures could impose more costs than the deposit insurance agency had anticipated. The system will need back-up sources of funding to cover this contingency. It could have a government guarantee, a right to borrow without limit from the treasury/the national debt office, the central bank, or from the markets.42 In addition, the deposit insurer might purchase reinsurance coverage from private insurance companies, although such companies typically do not have resources that are adequate to cover systemic banking problems. As indicated above, provisions should be made for the government to cover shortfalls in the fund by. for example, imposing an ex post levy or additional insurance premiums stretched over time. This provision will reduce the impact of the system’s demands on the budget in the longer term and will enhance financial stability and fiscal sustainability. Partly because the central bank has very limited capital of its own. IMF staff have generally recommended that the government, not the central bank, support a system, although a central bank may provide temporary lender-of-last-resort support to a system with a government guarantee.43

The Government Guarantee

The following points should be considered when a government guarantees the deposit insurance agency:

  • The government’s explicit and irrevocable guarantee should be provided under the law that establishes the deposit insurance agency. The fund may need a government guarantee to be credible with the public. If banking supervision is strengthened and the agency is properly managed, there should never be any reason to activate this guarantee.

  • To maintain the credibility of the system, the agency should have the power to borrow according to rules but without any limit on the amount needed to restore its viability from the treasury/debt agency or the central bank and issue bonds and notes in the markets. The agency would have no authority to take a loan from any other financial institution. The agency could need to borrow if it were to have insufficient resources to pay out or transfer deposits. It could be illiquid but solvent, because it had invested in long-term government securities for which there may not be a liquid market. In this situation, it could discount its assets or borrow against its assets from the central bank. It could also be allowed to borrow from the markets.

  • The agency would not need to provide good collateral against loans from the central bank where it has full government backing. (The central banking act should reflect this recommendation.) The government’s guarantee of the deposit insurance system would ensure that any central bank liquidity support is repaid. The agency would not need prior approval from the ministry’ of finance to borrow from the central bank.

  • The deposit insurance agency would need to seek prior approval (from the ministry of finance and central bank) regarding the liming of borrowing from the markets. Given the government guarantee, the agency should be required to seek prior approval from the ministry of finance for any borrowing in the markets, to avoid a situation where such borrowing would conflict with the timing of other government issues or with the objectives of monetary management.

  • The agency should have the authority to impose special, additional, ex post assessments on all member institutions, as needed: for example, to repay borrowed funds. The law should specify a limit to the combined assessments that could be imposed on banks in any one year. For example, analysis might reveal that it would be unwise to let the sum of regular and special assessments exceed 1 or 2 percent of total deposits in any one year. However, although the industry would not have the capacity to pay an unlimited amount in any one year, special assessments could be repeated until borrowed funds are repaid.

A Summary of IMF Advice

The recommendations above seek to create an incentive-compatible system of deposit protection to keep the banking system sound and to avert crises. A properly designed system of deposit protection can help underpin the stability of the system while limiting government outlays, if it is introduced (1) in situations of reasonably solvent (possibly restructured) banks: (2) with the support of adequate prudential regulation and supervision; and (3) if accompanied by well-formulated lender-of-last-resort policies by the central bank or others.44 The severe problems in the U.S. savings and loan industry in the 1980s demonstrated that a poorly designed deposit insurance system can weaken internal controls, thwart market discipline, and hamper supervisory action. Consequently, good design is important. While a weak incentive structure will not necessarily make a system insolvent, it may lead to higher premiums or additional supervision and regulation, both of which will be opposed by the banking community as limiting the growth of their industry.

The IMF has advised that deposit insurance can assist in the maintenance of a stable system, but only if it is accompanied by an effective system of supervision and clear legislation, including firm entry and exit policies. An efficient and competitive banking system should allow for entry of new banks (that are adequately capitalized and have fit and proper owners and managers) and, more important, should force the early exit of nonviable and insolvent banks whose presence can distort competition and lead to a rapid buildup of losses.45 The legal and supervisory framework should allow for a spectrum of prompt corrective actions to restore troubled banks to health, or facilitate their resolution in order to keep individual insolvencies from developing into systemic unsoundness. However, prompt exit reduces the losses that are incurred and is facilitated by formal provisions that protect small depositors from loss. Such protection helps to avoid the public complaints and political pressures that often accompany the closing of uninsured banks. Fears of public outcry have sometimes persuaded officials to keep troubled banks operating unresolved until runs occur.

IMF advice has cautioned that, as far as possible, deposit insurance should not be introduced in situations where banks are widely believed to be insolvent and where banking supervision is inadequate. The reason is that in such situations, the government will be tempted to give depositors a comprehensive guarantee that will be very expensive for it to underwrite and that it may not have the means to support. In addition, such a full guarantee may reward those who allowed the banking problems to occur in the first place. An additional problem is that it may allow the authorities to avoid taking the measures that are needed to strengthen the system, and so set the stage for a repetition of problems in the future.

With or without a system of deposit insurance, despite all precautions, careful design and implementation of the system, mistakes may be made and/or contagion can bring a banking crisis even to well-prepared countries. In that event, additional measures that are discussed in Section IV may become necessary.

Actual and Good Practices
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    Ratios of Deposit Coverage to per capita GDP in Selected Countries, 2000

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