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Deposit Insurance
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Introduction about deposit insurance

• Protection for your savings, in case your bank
  goes burst.
• Deposit insurance aims to prevent them from
  panicking and causing a bank run,and thereby
  reduces systemic risk
• The downside of deposit insurance is that it
  creates a Moral Hazard
• The state safety net could be shrunk,by splitting
  banks into 2 types narrow bank , Broad
  bank
• requiring every bank to finance a small
  proportion of its assets by selling subordinated
  debt to other institution.

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History
Benefit

• Stabilize the financial system
• Enhancing public confidence and systemic
  stability
• Increase saving and encourage economic growth

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The pitfalls of Deposit insurance

• Moral Hazard By insulating depositors from
  defaults,deposit insurance reduces their
  incentive to monitor bank closely.Also banks can
  take greater risks, safe in the knowledge that
  there is a state-financed safety net to catch
  them if they fall.
• Adverse Selection occur when the weak
  institutions choose to join a voluntary
  system,while the strongest remain outside.
• Agency problem This problem can occur when an
  agent serves his own interest rather than those
  of the principal who employ him

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Objective

• providing consumer protection for small
  depositors
• enabling small and new banks to compete with
  large and \ or state-owned banks
• defining the boundaries of the governments
  exposure to loss
• require banks to contribute to the resolution of
  failed peers

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The Deposit Insurance Systems Mandate Private
or Public

• private run and entirely privately funded
• government-backed and run

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The Systems Mandate Narrow or Broad

• Narrow Mandate
• Broad Mandate

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The Narrow Mandate

• insure small depositors in member institutions
• compensate insured depositors in failed member
  institutions promptly to minimize disruption to
  the economy
• setting and colleting premiums
• managing the insurance fund in a way that allows
  it to satisfy its obligations effectively
• informing the public of its role and
  responsibilities ,and describing how it works

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The Broad Mandate

• Monitors the condition of the banking industry to
  estimate its potential losses and take actions to
  minimize or forestall those looses
• Take responsibility for the resolution of insured
  financial institutions that have been intervened
  by the supervisors authority

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Infrastructure

• Deposit insurance systems need to be supported by
  a strong infrastructure of civil and commercial
  law.
• A clear understanding of their fiduciary
  responsibilities by bank owners and managers
• Internationally accepted accounting and auditing
  standards
• Public disclosure of individual bank data
• The system also needs to be supports by a
  well-formulated lender of last resort and
  adequate risk-management framework in the payment
  system.

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Deposit Insurance System Need To Be Supported
By...
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Supervision,Regulation,and Resolution
The regulatory and supervisory system should

• having the supervisory authorities for forcing
  the strict resolution of problem banks ,using a
  swift application of a spectum of enforcement
  actions to be taken as soon as a bank becomes
  undercapitalized or show sign of weekness.
• requiring and enforcing capital requirements also
  protect deposit insurance system.
• high deductible in property reluctant to take
  excessive risk.

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Supervision,Regulation,and Resolution
The regulatory and supervisory system should
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• . restricting the insured bank to holding only
  safe assets
• in Broad mandate,The supervisor needs authority
  to close and liquidate or resolve insolvent banks
  in some other incetivecompatible manner

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Requiring subordinated Debt

• Its holders are at the back of the queue for
  their money if the bank gets into trouble and
  they have no safety net
• To sell its debt,the bank will have to persuade
  informed investors .If it cannot convince them it
  cannot operate
• Requiring subordinated debt is feasible only for
  large publicly traded banks

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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 troubled bank
• Legal framework will help to avoid costly delays
• Broad mandate case,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.

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Country specifics

• Deposit insurance is best suited for an economy
  with a relatively large number of banks operating
  according to the same rule
• Deposit insurance is not suit for country which
  have

1 . size-that is,one or a few very large banks
and some or many smalls ones 2. ownweship that
is,a few dominant state-owned banks that may
carry explicit or implicit guaruntees of all
their deposits 3 . soundness that is , a few
well managed and solvent banks togetherwith a
significant number and share of insolvent and/or
nonviable banks
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OwnershipState-Owned Banks

• Government commonly institute a system of deposit
  insurance when there are a few,large state owned
  banks that have implicit guaruntees and a number
  of smaller or newly-chartered private banks.
• These can help to build the systems resources
  and somewhat redress the state institutions
  competitive advantage

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Fragility

• Explicit deposit insurance should be installed
  when the banking system is sound
• Countries are often impatient and reluctant to
  wait for this opportune time ,however deposit
  protection can prospone a banking debacle,but it
  is unlikely to prevent one
• Some country may have more lefitimate reasons for
  starting a system of deposit insurance .

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Avoiding Moral Hazard

• 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 to encourage all
  of the parties involved to act in ways that serve
  to strengthen the banking system

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The steps that can be taken to contain Moral
Hazard

• Make the Deposit Insurance System Transparent
  Transparency is essential because it allows bank
  customers to protect their interests
• Define Deposits Both the deposit insurance
  agency and institutions covered by that agency
  carry a responsibility to publicize which
  deposits are insured and which are not

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• Information for the Supervisor and the Deposit
  Insurance Agency The supervisor needs accurate
  and timely information on the condition of each
  bank .

The deposit insurance authority with broad
mandate needs to know the condition of banking
industry in general and of weak institutions that
mightimpose costs upon it so that it may plan for
payouts and choose resolution strategies Findin
g a way for the supervisor in a deposit insurance
agency to share information and satisfy each
agencys specifics information needs is a
challenge. However,the law should specify what
information the deposit insuer is entitled to
receive and what information the supervisor is
obliged to convey promptly.

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• 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 help keep
  the banking system sound through market
  discipline.
• Coverage Which classes of depository
  institution should be required to join the system
  of deposit insurance , which financial instrument
  to cover , and to when extent to cover them

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• Which Institutions to cover? A country may
  choose to institute a seperate scheme to cover
  such depository institutions .This scheme may
  offer lower coverage, or change higher premiums
  in order to cover the additional risks attendant
  on inferior prudential
• Which Instrument to cover ? Which instruments
  to cover by deposit insurance and the limits on,
  and exclusions from, coverage.

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The type of deposits to be included, and
establish that both principal and interest would
be covered

• 1 ) Deposit insurance of all types that are
  dominated in domestic currency , should be
  covered
• 2) Promissiory notes that are often tssued by
  finance companies would be covered by the system
  if finance companies are allowed to join the
  scheme
• 3) Both principal and any accured interest that
  has not already been added to the principal would
  be coverd
• 4 ) For trust accounts, one person should be
  designated to represent the group,which would be
  entitled onle to coverage for a single person
• 5 ) Foreign currency deposit where foreign
  currency deposits are widely used , and
  particularly ,The deposit insurance system may
  insure foreign currency deposit to promote
  financial stability

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• Which Instrument to Exclude ? The exclusion of
  bearer instruments can be justified because it
  would be impossible to implement the required
  limitations on coverage
• Other Nonessential Exclusions The careful
  supervision cen prevent problems about insider
  who often receive special privileges

• Some countries exclude deposits carrying
  excessively high interest rates from coverage.
• The supervisor should deal with such problems
  rather than encumber the deposit insurance system
  with a supervisory responsibility.

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• Extent of Coverage The deposit insurance
  scheme should be designed to protect small
  depositors .Excluding larger depositors to
  monitor the condition of their bank carefully.
• Coverage for Each Deposit or each Depositor
  Compensation should be paid up to the limit on
  the sum of depositor in any member institotion.
• Amount of Coverage The aggregate amount of
  coverage offered to each depositor in any bank
  should be relative low.

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• Coinsurance Coinsurance has the advantage of
  assuring depositors of the prompt repayment of at
  least part of deposit.It is often run on a
  sliding scale,so that the depositror recover.
• Should the Coverage limit be indexed to
  inflation ? The ideal situation is one where a
  country has low inflation

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• Netting Deposits Against Loans When a depositor
  is also a debtor of the failed bank , his/her
  deposit should be netted against the loan.
  However, should not be offset a good borrower.

• The insured parts of deposits of all kinds be
  netted against
• claims that have have already fallen due
• promised, but undelivered,subscription from
  shareholders
• damage assessments against owner and manager.

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Reducing adverse selection

• Make membership compulsory
• Risk adjustment premium

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Make membership compulsory

• membership in the system should be mandatory for
  all institution located in the country.
  Otherwise,only the weakest institution will join
  and the system will not be financially viable.

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Risk- adjustment premium

• The objective of risk adjusting premiums is to
  require riskier institutions that are more likely
  to call upon assistant from the deposit insurer
  to pay more coverage

- One straight forward method is to ask bank to
pay premiums based on their risk adjusted
asset,rather than on their deposit - A second
approach is to charge lower premium to banks that
have higher capital ratios and/or supervisory
rating
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Minimizing Agency Problem
To minimizing agency problem banking system
should avoid these problems

• 1 ) Political interference The agency need to
  be support by a clear legal and regulatory
  framework to limit political interference
• 2 ) Regulatory capture is a situation where
  the deposit insurance agency serves the bans
  rather than the interst of the public problem
  arise only when a privately fund has government
  financial backing . It can be solve by having the
  government run the scheme even though , It is
  owned by the banks

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Minimizing Agency Problem

• 3 ) Interagency friction is a lack of
  cooperation between or within financial
  regulatory agency to remedy this problem,The
  objective and function of different financial
  authorities must be clarified.

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Promoting Credibility

• The design of the deposit insurance agency can
  importantly influence its credibility. The agency
  should be design to be independent but
  accountable and have adequate management and
  staffing

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• Independence Refer to status within the
  government and to freedom from political pressure
  and domination by the banking industry .
• Accountability the authorities must maintain
  its books and record a transparence way and be
  subject to the same audit rules as other public
  entity The records of a public deposit
  insurance agency must , therefore,be subject to
  published annual audit conducted by the Office of
  the Auditor General or its equivalent.

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• . Staffing The propose deposit insurance agency
  could have a small staff in a country where there
  is not a large number of insure institution and
  failure are rare.
• Public Relation Such a program require that the
  deposit insurer issue publication that keep the
  public inform about coverage under the guarantee.

-The staff must be granted legal protection
against lawsuits -Staff would need analytical
skill and high integrity
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Ensuring Financial Integrity

• A financial issued that need to be resolved
  before setting up a system is How to fund the
  system.Resolving this issues will improve the
  financial position of the system and reduce its
  need to call on government resources for back up

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Optimum fund size

• There are 2 separate philosophies reguarding fund
  size
• 1 ) Aim to have a fund large enough to self
  sufficiently compensate when bank failure occur
  in a normal time.
• 2 ) Reduce fund size but only to a level that
  enable a system to borrow ,to pay depositor in
  failed bank.

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• Start up Funding A newly established system may
  receive initial contribution for bank/Central
  Bank / Government. Where are strong initially to
  foot the bill they should do so.
• Ongoing Funding-Premium Insurance fund would
  be accumulate and member would be required to pay
  premium at the rate of X percent per year
  based on total deposit
• - Premium would be levied as needed to cover
  expenses and build, maintain or rebuild the fund
  to its target level

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• Deposit 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 funds net
  outlays , while increasing the share of losses
  borne by others .
• The choice between granting priority and not
  granting it is judgement call. Yhe choice would
  be influenced by an assessment of the balance
  between a fiscal need and deposit insurance
  system efficiency in recoveries.

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• Managing Fund Assets Another defense of the
  fund is to invest fund resources wisely.
• When investing fund resources
• Should be in vested in government securities.
• Should determine the most appropriate maturity.
• Sholud have market interest on the fund and
  safety
• Even government paper may not always be
  sufficiently liquid insurance system may wish to
  invest in government securities abroad

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• Back-up Funding It could have a government
  guarantee,a right to borrow without limit from
  the treasury/the national debt office,ihe central
  bank ,or from the market.
• The Government Guaruntee The following points
  should be considered when a government guaruntees
  the deposit insurance agency

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• The fund may need a government guarantee to be
  credible with the public.
• The agency should have the power to borrow
  according to rules but wiyhout 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 governments guaranteeof the deposit
  insurance system would ensure that any central
  bank liquidity support is repaid
• Agency would need to seek prior approval ( From
  the ministry of finance and central bank )
  regarding the timing of borrowing from the
  markets
• The agency should have the authority to impose
  special ,additional ,ex pose assessment on all
  member institutions,as need for example,to
  repay borrowed funds.

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Case study Germany

• The German Deposit Insurance System
• The German banking system Large share of public
  and cooperative bank
• The German traditionallly been universal banks
  doing both commercial and investment banking and
  serving both household and firms

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General Characteristics of German deposit
insurance schemes

• There are 3 major deposit insurance schemes in
  Germany
• Establish under political pressure
• Organization administration has been private
  from the beginning
• Each of 3 main German bank groups has its own
  deposit insurance scheme
• Offset the competitive advantage that the saving
  bank has due to their public ownership

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General Characteristics of German deposit
insurance schemes

• Saving banks and cooperative bank group has both
  regional and national insurance schemes
• The schemes of both saving and cooperative banks
  do not directly guarantee deposits, but rather
  the institution themselves
• All 3 bank groups have their own auditing
  entities and work closely with the Federal
  Banking Supervisory Office and the Budesbank
• Bundesbank is prohibited by law to act as lender
  of last resort for the deposit insurance schemes.
  It is rater expected that in the case of a
  systemic crisis, a political solution will be
  found without this case being predictable

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Membership

• Voluntary but compulsory for all members of the
  German Bank Assosiation
• Although membership is Voluntary,
  non-participating banks face high barriers
• Member of a deposit insurance scheme cannot use
  their membership for advertisement purposes
• Non member has to post the fact that it I s not
  a member in its General Terms and condition and
  in the schedule of prices displayed in the
  banking hall and on the application forms for
  opening an account

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Coverage

• All non bank deposit are covered up to a limit
  of 30 of liable capital of troubled institution
• Given that minimum capital for a bank the minimum
  limit is 1.5 million Euro
• Given that average equity size of a commercial
  bank is 295.6 Euro ,the average limit is around
  90 miilion Euro
• It is very high limits make the coverage almost
  complete

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Financing

• Fiananed exclusively by member bannks and on a
  mixed ex-ante and expost basis
• Member bank have to pay premium of 0.03 of
  liabilities to other creditor arising from
  banking business every year
• Additional payment of 0.09 for new members
• Banks that have paid for more than 20 years and
  are classified in the lowest risk category (A),
  can be exempted from premium payment

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Financing

• Banks that are classified as higher risk (B or
  C) are required to pay an additional premium of
  up to250 of the regular premium.
• Available fund are not publicly know
• No public funding
• The Bundesbank is prevented by the Bundesbank act
  to function as lender of last resort

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Management

• Organized within the German Bank Association
• Under management by laws of private association.
• No public supervision
• Flexible in terns of how it assists a troubled
  bank

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Auditing

• All member banks have to be member of the
  Auditing Association of German Banks, that audits
  and classifies banks on a yearly basis
• Cannot be used in advertising
• Classification criteria are the financial
  situation and quality of management
• The Auditing Association of German Banks can
  impose corrective actions on the member banks if
  there are circumstance that increase the
  riskiness of the banks bussiness or other
  circumstances that violate the banking act or
  other laws referring to bank business

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Case study FDIC

• The Federal Deposit Insurance Corporation (FDIC)
  preserves and promotes public confidence in the
  U.S. financial system by identifying, monitoring
  and addressing risks to the deposit insurance
  funds and by limiting the effect on the economy
  and the financial system when a bank or thrift
  institution fails
• . The start of FDIC insurance on January 1, 1934

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• It is funded by premiums that banks and thrift
  institutions pay for deposit insurance coverage
  and from earnings on investments in U.S. Treasury
  securities.
• Savings, checking and other deposit accounts,
  when combined, are generally insured up to
  100,000 per depositor in each bank or thrift the
  FDIC insures.
• The FDIC insures deposits only.
• The FDIC is the primary federal regulator of
  banks that are chartered by the states that do
  not join the Federal Reserve System. In addition,
  the FDIC is the back-up supervisor for the
  remaining insured banks and thrift institutions.

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• To protect insured depositors, the FDIC responds
  immediately when a bank or thrift institution
  fails. Institutions generally are closed by their
  chartering authority
• The FDIC has several options for resolving
  institution failures, but the one most used is to
  sell deposits and loans of the failed institution
  to another institution.
• Insured banks also pay the FDIC money four times
  a year to keep being insured.
• The money the FDIC collects from banks is put
  into two different accounts The Bank Insurance
  Fund, and the Savings Association Insurance Fund,
  or BIF and SAIF for short.

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Issues for Reform

• Merge BIF and SAIF
• Reduce statutory Restrictions on Premiums
• Relaxing the Reserve Ratio Regime to Allow
  Gradual Adjustments in Premiums
• Modify the Rebates System
• Indexing Ceiling on the Coverage of Insured
  Deposits

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The End