DESIGNING AN EFFECTIVE DEPOSIT INSURANCE STRUCTURE:

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DESIGNING AN EFFECTIVE DEPOSIT INSURANCE
STRUCTURE AN INTERNATIONAL PERSPECTIVE Sponsore
d by Financial Stability Forum and Federal
Reserve Bank of Chicago December 12,
2000 Robert A. Eisenbeis
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Introduction

• Comment on basic premise - that countries should
  adopt deposit insurance
• Discuss some of considerations in embarking upon
  transition
• Some concluding remarks

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Key Problem - Moral Hazard

• Paper admits that moral hazard goes hand and hand
  with Deposit Insurance
• Interesting conflict - deposit insurance
  interferes (reduces) with market discipline when
  not properly priced
• But discipline is needed to control risk taking
  incentives
• What kind of discipline is desired and how much
  is enough?
• Unstated, but really discipline can be exercized
  through either price or quantity of deposits
  available.
• Price discipline is good, but quantity discipline
  (while good as far as individual institutions is
  concerned) hold prospect of runs
• With deposit insurance regulation must function
  to mimic market

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What is Deposit Insurance Designed to Do?

• D.I. protects against runs by unsophisticated
  investors?
• Is this the chief source of financial crises in
  most countries - No.
• Misguided fiscal policies
• Run away inflation inflation
• Policies designed to stimulate rapid growth to be
  financed by borrowing externally in foreign
  currencies
• Clark Warburton - macro instability
• Main function of deposit insurance relates to
  risk and burden sharing and specifically to avoid
  imposing costs on small depositors
• Risk that proposals dont fit the problem

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Does It Make Sense to Provide Riskless Asset to
Public by Guaranteeing Liabilities of Private
Sector entity?

• Doesnt make much sense in developed
  economy-costly way to do so and interferes with
  incentives
• Makes no sense in developing economy with no
  credibility
• Mistake to promote D.I. in todays market place.

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Will Deposit Insurance Help Prevent or Moderate
Crises?

• D.I. puts public sector explicitly on the hook
  for bad policies.
• Implicit and explicit guarantees creates
  obligation for governments to back up banking
  system and promotes forbearance as main short
  term policy response.
• Research (Demirg?c-Kunt and Detragiache(2000)
  suggests that D.I. May increase chance of crisis
• Forbearance combined with bad policies ups costs
  of financial crises to the public.

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What Should Be the Goals of Deposit Insurance?

• Make failure isolated events
• While protecting taxpayer
• Avoid forbearance at all costs.
• Impose losses on creditors, preferably only
  equity holders
• Avoid interference with managerial decisions in
  healthy institutions

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Study Lists Features That DI Should Have To Limit
Moral Hazard and Promote Mkt. Discipline -Can
This Be Realized?

• Insurance limits
• Coinsurance
• Partial coverage
• Depositor preference
• Risk-Related Premiums
• Mandatory subordinate debt

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• Capital requirements
• Need to be market based and
• Related to closure policy
• Early intervention and PCA
• Personal liability
• Good corporate governance and management
• Regulatory discipline
• Will to impose costs on creditors and bank owners
• Credible closure policy

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Which of Proposals Are Consistent With Goals?

• Early intervention and PCA - If implemented
  properly, then no need for deposit insurance
  since only equity holders should incur losses
• Exceptions would be in case of fraud, measurement
  error or when forbearance was followed.
• It is because of forbearance that regulators must
  be subject to strong sanctions to avoid
  forbearance.
• With measurement error, there is strong rationale
  for closing institutions while measured net worth
  is still positive.
• Properly implemented, PCA eliminates need for
  capital requirements
• Also limits need for concern about activities as
  long as can be valued
• To induce institutions to reveal values of (or to
  avoid) hard to value activities, need to charge
  them for exams.
• Want risk monitoring and closure to be vested in
  insurance agency that takes the loss when a
  failure occurs.

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An Aside on Risk Related Premiums

• Not particularly effective
• Need institution to pay premium and separately to
  pay monitoring costs to incent institutions to
  reveal problems
• Premium setting problems are same as setting
  capital adequacy requirements - only differing as
  to how charges are to be imposed

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Key Points - Need Infrastructure Before Insurance

• Well developed capital market to impose market
  discipline
• Sound legal system with few uncertainties in
  resolving claims
• Well defined closure rule - key to making
  failures independent events
• No govt owned banks
• Separate agency for banking regulation and
  insurance from central bank or Treasury due to
  conflicting goals (Wall and Eisenbeis(1999)

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• No separate deposit insurance fund and only if
  full faith and credit
• Only rationale is that fund is petty cash to lend
  to liquidation
• Perpetuates fiction that banks own fund
• Insurance is term not cash value life insurance