Deposit insurance
Deposit insurance is part of the ‘‘safety net’’ for the banking system, but also can contribute to the system’s instability, depending on its coverage and design. Deposit insurance has cross-border implications through its impact on banking crises that potentially spread to other nations.
In most countries, the regulatory structure for banks is much farther reaching than regulation of nonfinancial firms as well as of nonbank financial institutions. The case for regulation is based on special characteristics of banks and perceivedmarket failures in banking. First, the double role of banks as liquidity providers and participants in credit and capital markets makes them potentially vulnerable to bank runs, since a large share of the assets cannot be liquidated quickly in case depositors want to convert their funds to cash. Second, banks are relatively opaque entities, making it difficult for depositors and other creditors to evaluate the default risk of each bank. The limited information among depositors about the risk and value of bank assets can lead to the spread (contagion) of bank runs from one bank to another (Diamond and Dybvig 1983).Third, there are generally substantial amounts of very short short-term interbank liabilities, which contribute further to the risk of contagion. The potential for contagion implies that the banking system is subject to ‘‘systemic risk’’ to a greater extent than other providers of credit. Fourth, banks play a key role in payment and settlement systems, with the implications that large failures can disrupt economic activity.
The risk of runs on a bank and contagion implies that speed of action is of the essence when a bank is perceived to be near failure. Conventional liquidation and restructuring procedures for corporations are too time-consuming to be applied to banks without modification.
Some economists argue that banks are not qualitatively different from other firms and that markets provide sufficient discipline on banks’ risk taking. These economists, who generally are proponents of ‘‘free banking,’’ are few, however. From a policy point of view it is most important which view dominates among policymakers. It can safely be said that in times of crisis they will not be willing to experiment in order to find out which group of economists is right.
The need for rapid intervention, lack of effective rules for dealing with a bank in distress, and fear of contagionwork in tandemto compel governments to intervene in a crisis by issuing blanket guarantees to all creditors or bailing most or all of them out. Anticipating this government behavior, depositors, other creditors, and sometimes shareholders as well perceive themselves as implicitly insured even if there is no explicit deposit insurance.
The Safety Net for the Banking System
The features of banking described earlier have led to the implementation of a number of measures in most countries that together constitute the safety net for the banking system. The typical components of the safety net are:
- A lender of last resort (LOLR)
- Deposit insurance
- Supervision and regulation of banks’ risk taking
- Capital requirements
These aspects of the safety net should jointly protect the ‘‘safety and soundness’’ of the banking system while providing bankswith the appropriate rules and incentives to allocate credit efficiently. Deposit insurance can limit the risk of bank runs by guaranteeing that depositors receive some, or all, of their deposited funds with reasonable speed in case their banks become insolvent or illiquid.The central bank can also act as a LOLR by lending to a solvent bank facing a liquidity squeeze as a result of a run by depositors. To limit the LOLR to cases of illiquidity, the central bank can require collateral to provide liquidity support.
Regulation of banks’ behavior and asset allocation, and supervision of banks’ credit allocation and risk management systems, have the purpose of limiting banks’ risk taking, which can be excessive. In addition, capital requirements reduce risk-taking incentives by ensuring that there is always shareholder capital at risk. Capital also serves as a buffer against unanticipated losses.
International agreements with respect to capital requirements as well as principles for supervision are negotiated within the so-called Basel Committee. The first Basel Agreement was completed in 1988 (Basel I). After years of debate, a substantially revised CapitalAdequacyAccord(Basel II)was completed in 2004. This accord was to be implemented in the European Union (EU) in 2007 and 2008, but it remains controversial, particularly in the United States.
Deposit Insurance, Risk Taking, and Banking Crises
The flip side of the positive role of deposit insurance as a safeguard against bank runs and as a consumer protection device is its role in inducing banks to shift risk to a deposit insurance fund or tax payers. These risk-shifting incentives are caused by limited liability of shareholders and explicit or implicit protection of depositors and other creditors. The so called moral hazard problem caused by these factors implies that banks have incentives to take on excessive risk on the asset side or to keep the equity capital low. Thus deposit insurance systems can contribute to the very problem (systemic risk) they are designed to reduce.
One solution to themoral hazard problem would be to design a deposit insurance premium structure reflecting banks’ risk taking. Risk-based pricing encounters the problem of defining banks’ risk taking contractually. For this reason a private deposit insurance market is not likely to function well. The existence of explicit and implicit insurance also undermines the scope for private insurance. In the United States, the Federal Deposit Insurance Corporation (FDIC) sets insurance premiums based on levels of capital.
The substantial resources devoted to the design of a capital adequacy framework by central bankers and regulators in the Basel Committee indicate that there is a strong concern about incentives for excessive risk taking.Bankmanagers, by contrast, tend to deny that there are incentives for excessive risk taking because they do not deliberately set out to take ‘‘excessive’’ risk. Incentives need not reveal themselves as incentives for deliberate risk taking, however. Instead, it is the competition among banks with the opportunity to finance their lending activities at a near risk-free interest rate that induces them to prefer debt financing to equity financing. Furthermore, competition for funding will not be based on banks’ risk evaluation and risk management skills. Increased resources devoted to regulation and supervision and increased sophistication of supervisors have done little to reduce the incidence of banking crises. For this reason several academic economists have called for increased reliance on market discipline in the regulatory framework for banks.
The existence of implicit insurance implies that it is not necessarily the extent of explicit insurance that determines creditors’ and, indirectly, banks’ behavior. Absence of explicit insurance does not constitute credible noninsurance if political realities require supervisors and governments to rapidly intervene in banking crises to protect creditors.On these grounds a deposit insurance schemewith limited coverage can maximize themarket discipline bymaking it credible that noninsured deposits and creditors will not be bailed out (Angkinand and Wihlborg 2006). The appropriate coverage depends on a number of country-specific institutional factors affecting credibility of noninsurance. In particular, effective procedures for dealing with a bank in distress can reduce the likelihood of bailouts.
The empirical evidence on the relationship between the coverage of deposit insurance schemes and risk taking is ambiguous. Much work has been devoted to analysis of the relationship between deposit insurance coverage and the occurrence of banking crises around the world.
Differences in results across studies suggest that institutional differences matter greatly for the effect of deposit insurance on the likelihood of banking crisis. The economists Demirgüç-Kunt and Detragiache (2002) consider the effectiveness of prudential regulation and supervision, as well as the strength of the legal system, finding that deposit insurance contributes less to the probability of banking crisis in countries with a high level of institutional quality.
Banking crises and excess risk taking have also been analyzed at the bank level. On this level it is necessary to take into account that capital and risk taking are determined simultaneously. The economists Nier and Baumann (2006) found that bank capital is decreasing in deposit insurance coverage, increasing in uninsured deposits, and decreasing in government support. These results provide evidence thatmarketdiscipline depends on explicit coverage as well as the credibility of noninsurance.
Dimensions of Deposit Insurance Systems
Several dimensions of explicit deposit insurance schemes can discourage bank runs and incentives for risk taking. In discouraging bank runs, speed and credibility of insurance compensation in case of a bank failure are particularly important.
Risk-taking incentives are influenced by the existence of groups of creditors with incentives to monitor banks and to withdraw funds if they find that a bank takes unacceptable risks. Demirgüç-Kunt and Detragiache (2002) constructed a ‘‘moral hazard index’’ for a large number of countries from data on coinsurance features, coverage of foreign currency and interbank deposits, type of funding, source of funding, management, membership, and the level of explicit coverage. Coinsurance implies that those insured are responsible for parts of the losses. Foreign currency and interbank deposits are not covered in most countries. Private participation in the deposit insurance system can also be required.
Funding can be through insurance premiums that are used to build up a fund, or governments can cover payments out of tax revenues when compensation is due. The existence of a fund enhances the credibility of the systemand it implies that banks pay insurance premiums, which can be based on proxies for risk. Most countries either do not charge a premium or they charge a certain percentage of deposits. The method to replenish losses to a fund, and assign responsibility in case the fundis insufficient, also affects incentives. If banks are held responsible for the replenishment of a fund, the subsidy component to the insurance systemis reduced and banks have stronger incentives to watch the soundness of the system. Finally, membership in the system can be voluntary or required.
The economists Hovakimian, Kane, and Laeven (2003) have estimated implicit insurance premiums for banks in a number of countries based on the insight that deposit insurance can be interpreted and valued as a put option on banks’ assets (i.e. the right but not obligation to sell). The authors find that some risk-adjustment of the insurance premium for each bank, the existence of coinsurance, and the funding of the deposit insurance along with deposit insurance coverage affect the variation in implicit insurance premiums across countries.
Deposit Insurance in Cross-Border Banking
Banks are involved in cross-border activities through direct lending to foreign banks, companies, and governments; through subsidiaries; and through branches operating in foreign countries. In the first case the domestic deposit insurance system affects the incentives for lending to foreign entities and protects domestic depositors. Implicit insurance can also be provided by international financial institutions, in particular the International Monetary Fund (IMF). The IMF’s role in helpingMexico during the crisis in 1995 has been widely blamed for contributing to the Asian crisis in 1997. The IMF does not protect banks directly but by helping countries such as Mexico in balance of payments crises, it indirectly provides protection for banks that have lent to banks and the government in a crisis country. As a result banks may consider loans to foreign governments and banks protected by the same governments to be relatively safe.
Foreign subsidiaries are separate legal entities. Depositors in subsidiaries are therefore protected by host country deposit insurance systems. Host countries are also responsible for supervision of the subsidiaries while home countries are responsible for supervision of the consolidated bank. Since subsidiary operations often are closely integrated with the parents in complex financial organizations, there are opportunities for shifting of risk between the entities. If a subsidiary or the consolidated bank fails there is scope for conflicts of interest between host and home countrieswith respect to the sharing of the burden for losses that are not clearly attributable to one of the entities. The absence of predetermined procedures for crisis resolution in banks makes conflictsmore likely. It is common for home and host countries to have memoranda of understanding on crisis resolution for banks, but thesememoranda are typically so general that they offer little guidance if a bank fails.
A bank can also run its host country operations through branches. Since branches are not separate legal entities, the challenges for authorities in home and host countries are different. The EU’s Banking Directive provides banks with the opportunity to operate across borders within the EU through branches under home country supervision. Deposit insurance in the EU is also a home country responsibility. Thus banks of different nationalities can operate in the same country offering different levels of deposit insurance. If a host country has a higher coverage, local branches of foreign banks can be offered the opportunity to ‘‘top up’’ their deposit insurance. The EU rules with respect to deposit insurance and supervision are consistent in the sense that the responsibilities for insurance and supervision coincide. Nevertheless, there is substantial worry in host countries that their interests will not be well represented if a foreign bank fails. These concerns partly explain why the Banking Directive has not been put into large-scale practice; instead, most cross-border banking is organized in subsidiaries.
The situation in the United States is different. Branches of foreign banks must participate in the U.S. deposit insurance system, although they are foreign legal entities and formally relying on the same capital as buffer against losses. To protect the American interests in case a foreign bank fails, branches of foreign banks are ‘‘ring-fenced,’’ meaning that the branchesmusthold separate capital for their activities in the United States. Therefore, the difference between a subsidiary and a branch in the United States is almost in name only. See also asymmetric information; bailouts; contagion; discipline; financial services; International Monetary Fund (IMF); lender of last resort; spillovers