Funding of the deposit insurance scheme

6. Funding of the deposit insurance scheme

There are two main funding arrangements. One is to set up a fund with regular contributions from insured banks out of which claims can be met. The other approach is unfunded, or with a relatively small initial fund, taking an ex post approach with premium assessments levied after bank failures. Fig. 3 shows the decisions that need to be made with regard to the financing of a deposit insurance fund. Some have argued that since a government may be responsible for the failure of a bank and yet also benefits from banking stability, it should bear part of the deposit insurance costs. Both types of funding arrangement have a moral hazard impact and Fry et al. 1996 have remarked that the conversion from implicit deposit protection to explicit deposit insurance would result in less moral hazard for banks but more moral hazard on the part of the depositors pp. 366 – 367. The creation of an explicit deposit insurance fund, with premiums collected from insured banks on the basis of their deposits, would seem to be the most sensible approach to ensure depositor confidence 15 . An explicit fund would give more Fig. 3. Funding arrangement. 15 The EU Directive of May 1994 required each member country to adopt by mid-1995, an explicit system of deposit insurance. Official Journal of the European Communities, Directive 9419EU, pp. 8 – 9. psychological comfort to depositors, and the financial burden of the DPS could be more evenly spread. From Table 4, we can see that 49 countries have explicit deposit insurance funds with premiums collected from insured members. In the nine countries that do not maintain explicit funds, calls for premiums are made on insured banks only when necessary. In Chile, El Salvador and Kuwait, insurance funds are financed by the government. Tally and Mas 1992 report that in the former Yugoslavia, costs of the deposit insurance system are absorbed entirely by the government. In Argentina, Japan, Norway, Portugal, Spain, Taiwan, Trinidad and Tobago, and Uganda, the government contributes at least one-third of the funds. 6 . 1 . Premium assessment The most formidable technical problem in the design of a deposit insurance scheme is the determination of an appropriate premium structure. A properly structured premium system can be used to lessen moral hazard and reduce adverse selection effects. The acceptability of deposit insurance to the participating banks depends, to a great extent, on the design of the premium structure. The decision has great significance upon additional types of bank regulation required. Fig. 3 shows the choice of premium structure between a flat rate for all banks and a variable rate related to the riskiness of each bank. A flat-rate premium system is easy to implement, but leaves much to be desired. A premium structure related to the risk of each insured bank is sound in theory, but difficult to implement. The problem of how to assess premiums is complicated by the difficulty in calculating the amount of insurance funds necessary to meet the claims of deposi- tors. The loss to a deposit insurance fund depends on 1 the ceiling of protection; 2 the difference between the amount of insured deposits and the market sale value of the failed bank’s assets; and 3 when a problem bank is detected, and how fast the failing bank is closed, rather than on the riskiness of its portfolio. Horvitz 1983 has pointed out that the losses of a deposit insurance system are not closely related to the riskiness of insured institutions. Losses are for the most part, a function of when a failed bank or savings institution is closed. If a bank is immediately closed when its net worth is exhausted, then the premiums are only needed to cover the operational expenses of the deposit insurance agency. 6 . 2 . Risk-related premiums If deposit insurance premiums could be based on the specific risk of individual banks, then many of the inherent problems of deposit insurance would be largely overcome. To effectively lessen the moral hazard impact of deposit insurance, the precise measurement of a bank’s risk is crucial. However, the identification of a proxy for risk is not an easy task. In the US, the FDIC 1983a,b has suggested the Table 4 Funding of deposit insurance schemes a How funded Premium rates Country Premiums from participating banks Flat rate: 0.36 to 0.72 of annual deposits Argentina and government per year. Graduated contribution structure depending on the relative quality of bank’s portfolios. May be increased from three ba- sis points for banks based on risk indicators determined by the central bank Unfunded arrangement Austria Unfunded, calls on participating banks in the event of loss Premiums Flat rate: 0.04 of total deposits Bangladesh Belgium Flat rate: 0.02 of insured deposits, not Premiums more than 0.5 of deposits of each bank Flat rate: from 18 of 1 to 1 of insured Premiums Canada deposits, 0.016 of insured deposits Chile Funded, financed by Government None Flat rate: 0.5 of total deposits Premiums Czech Republic Premiums Columbia Flat rate: 0.5 of required reserves on de- posits Flat rate: 0.15, maximum 0.2 of total Premiums Denmark deposits until minimum size is attained El Salvador Unfunded, financed by Government NA Flat rate: 0.01 to 0.05 of total assets Premiums Finland France Flat rate, depends on losses, annual maxi- Unfunded, calls on participating banks mum Ff. 10 mn. Assessments based on de- in the event of loss posits Flat rate: 0.03 of insured deposits Premiums Germany Hungary Flat rate: 0.2 of total deposits and from Premiums, admission fee equal to 0.5 the weighted asset risk ratio of the institu- of the subscribed capital tions concerned, maximum 0.3 if individ- ual banks pose higher insurance risk Flat rate: 0.05 to 0.15 of all deposits re- Premiums Iceland spectively for commercial and savings banks India Flat rate: 0.04 of all deposits, half yearly Premiums basis Flat rate: 0.2 of deposits, min. Irish Premiums Ireland pounds 20 000; no max. Italy Unfunded, calls on participating insti- Unfunded. Variable, total amount fund set at 1 of total deposits, callable based on tutions in the event of loss. Fund ceil- ing is 4 trillion lire deposits and loans less capital and reassess- ment Japan Flat rate: 0.012 of insured deposits Premiums; initial funds from partici- pating institutions and government 1 3 Premiums Kenya Flat rate: 0.1 of deposits, minimum K Sh 100 000, maximum 0.4 of deposits Premiums plus contributions from gov- Flat rate: 0.02 of insured deposits, up to Korea 0.05 of insured deposits if risk-related ernment Kuwait None Funded, financed by Government Premiums Flat rate: between 0.02 and 0.05 of in- Lebanon sured deposits Table 4 Continued How funded Premium rates Country Insured deposits of surviving institutions, Unfunded, calls on surviving institu- Luxembourg tions based on percentage of loss to be met Marshall Islands Variable, follows the US model Premiums Premiums Mexico Flat rate: 0.3 of insured deposits, regular monthly contributions Premiums Variable, follows the US model Micronesia Unfunded, calls on participating insti- Netherlands Flat rate, annual contribution from individ- tutions in the event of loss ual institution not to exceed 10 of its core capital Premiums Nigeria Flat rate: 0.94 of 1 of all deposits Norway Flat maximum rate: 0.015 of total assets; Premiums and contribution from gov- government contributes an equal amount ernment Contributions from banks and govern- Oman Flat rate: 0.01–0.03 of total deposits ment on an equal basis Premiums Flat rate: 0.25 of deposits Paraguay Premiums Flat rate: 0.75 of total deposits, quarterly Peru basis Premiums Philippines Flat rate between 0.083 and 025 of total deposits, average 0.0667 of total deposits Poland Premiums Flat rate: 0.2 of deposits Based on previous year’s average monthly Premiums, half from government Portugal deposits Flat rate: 0.25 of deposits, 12 from gov- Contributions from banks and govern- Spain ment on an equal basis ernment Sweden Flat rate: 0.25 of deposits, annual basic Premiums fees may be varied, based on each bank’s capital ratio and aggregate result of the guarantee system Switzerland Flat and variable rates, depends on banks’ Unfunded, calls on participating insti- balances and total deposits tutions in the event of loss Flat rate: 0.015 of insured deposits Premiums and contributions from gov- Taiwan ernment Banks and government Flat rate: 0.1 of deposits Tanzania Premiums; government also partici- Flat rate: 0.2 of average deposits Trinidad and To- bago pates in the financing Premiums Flat rate: 0.3 of insured deposits Turkey Flat rate: 0.2 of deposits Uganda Premiums; government provides some funding Premiums, initial contribution of Flat rate but progressive levy with max. of UK 0.3 of domestic sterling deposits £10 000, further calls when necessary up to £300 000 US Between 0.195 and 0.23 of domestic de- Contributions from participating insti- posits from 1990, risk-based since 1993, tutions depends on individual bank rating, average 0.2435 for banks and 0.248 for thrifts in 1994 Venezuela Premiums Flat rate: 0.5 of total deposits every 6 months a Note: Details not available for Brazil, Greece, and Yugoslavia. According to Tally and Mas 1992, the Yugoslavian government absorbs all the costs of the system. Sources: Abdulrahman 1995; Andre and Axel 1995 pp. 18–20; Banker 1991 p. 19; Bruyneel and Miller 1995; Canada Deposit Insurance Corporation 1993; Carisano 1992; Economist 1990, 1995; Fry et al. 1996; Hong Kong Government 1992; Ko 1997; Kyei 1995; Fredbert 1995 pp. 60–61; McCarthy 1980; Norwegian Banking Law Commission 1995; OECD 1995; Pennacchi 1987 pp. 269–277; and Tally and Mas 1990, 1992. application of some key variables such as credit risk, interest rate risk and liquidity risk, in order to assess the specific risk of each bank for premium assessment purposes. Clearly, such a list cannot be exhaustive. The appearance of new sources of risk as a result of financial innovation e.g. derivatives has made any attempt at the precise measurement of risk factors very difficult. Therefore, Goodman and Shaffer 1983 argue that a risk-related insurance premium system will generally fail to cope adequately with new, previously unanticipated, sources of risk. They say it is like ‘a dog chasing its own tail’. A similar view is held by Berger 1994. The major problem of variable insurance premiums is the identification and measurement of risk characteristics of banks. For a variable premium structure to be successful, an extensive degree of information, continuous surveillance and supervision by regulators is required. This is a formidable task that requires advance knowledge of the precise risk-return schedules of all current on and off balance sheet activities. Thus far, researchers have not been able to identify any objective way of assessing insurance premiums. Horvitz 1983 and Kane 1986 warn that mispriced deposit insurance generates subsidies to stockholders, man- agers, and deposit brokers. They are the ones who are regarded as the true beneficiaries of deposit insurance. Several studies have also shown objections to the use of risk-sensitive premiums. For example, Goodman and Santomero 1986 advise that a variable-rate system raises the cost of funds to the real sector and increases the probability of bankruptcy for the borrowing firms. When such bankruptcies occur, society experiences a dead weight loss. Goldberg and Hariku- mar 1991 claim that in the absence of symmetric information between bank managers and the insurance agency, insurance premiums based on projected and actual risk levels do not control risk-taking incentive. They hold that the only way to control this incentive is to levy a relatively high premium, which is not fair in the actuarial sense. According to Chan et al.’s model Chan et al., 1992, when banks hold non-traded private-information assets, no equilibrium price for deposit in- surance exists, unless banks earn rent or are subsidized. Furthermore, Crane 1995 notes that the fair pricing of deposit insurance eliminates inequitable wealth transfers, but does not necessarily lead to an efficient equilibrium. Even if risk-based premiums could be objectively estimated and effectively implemented, we would still have to consider the problem that variable premiums may force weak institutions to seek even higher risk investments in order to absorb the higher premiums charged. It is unfortunate that a risk-based deposit premium structure does not automatically eliminate moral hazard. The practice of risk-sensitive premiums is extremely limited and only the United States, Marshall Islands, Micronesia and Argentina since 1995 relate their in- surance premiums to the riskiness of each bank 16 . Ko 1997 reports that Korea wishes to adopt a risk-related premium structure when such techniques are available. 16 The Federal Deposit Insurance Corporation in the United States classifies banks into nine risk categories according to their overall CAMEL rating. CAMEL is an internationally recognized frame- work for assessing capital adequacy, asset quality, management, earnings and liquidity. Banks with a higher CAMEL rating pay a lower premium rate. It is fair to say that assessment of premiums is the most problematic issue of deposit insurance 17 . The complex nature of implementing a risk-sensitive deposit premium system is summed up in the following quote from the FDIC 1983a 18 : The ‘ideal system’ with premiums tied closely to risk is simply not feasible. Such a system would require the FDIC to be given an extreme amount of authority. Moreover, it would entail unrealistic data requirements and much more advanced risk quantification techniques than are currently imaginable. 6 . 3 . Flat premium rate structure Because risk-related premiums are difficult to implement, a flat-rate premium schedule may be a possible alternative. A flat-rate premium structure is easy to understand and to implement. Indeed, a flat-rate deposit premium schedule can meet many of the criteria of a good deposit insurance structure 19 . As expected, criticisms of the flat-rate deposit insurance scheme are abundant. Among them are comments made by Buser et al. 1981, Benston et al. 1986, Goodman and Santomero 1986, Mussa 1986, Kane 1985, 1987, Duan et al. 1992, Wheelock 1992 and Shiers 1994. Most criticisms center on amplification of the moral hazard problem. Risk-seeking institutions are charged the same rate per insured dollar as conservative institutions. Thus, risk takers are not penalized for their aggressiveness. Many concede that the flat-rate premium structure in a sense, actually encourages risk-taking by insufficiently allocating the commensurate costs of risk. A related criticism is that sound banks, in essence, subsidize excessive risk-taking behavior of their competitors. With flat-rate insurance premiums and the way that the FDIC in the US always supports large banks with all the means at its disposal, depositors enjoy greater protection at large banks than at small banks. Thus, Keeton 1990 concludes that a flat-rate insurance premium system can unfairly discriminate against small banks. Needless to say, a combination of flat-rate premium system and full protection significantly exacerbates the moral hazard problem. The former may lead to excessive risk-taking by depository institutions, and the latter reduces the incentive 17 There has been a continuous stream of literature discussing the deposit insurance premium. Some examples of recently published studies are Hwang et al. 1997, Karels et al. 1997, and Hazlett 1997. 18 Also quoted in Scott 1986, p. 94. 19 The most comprehensive list of criteria is provided by Bierway and Kaufman 1983. They advocate that an ideal deposit insurance premium system should have explicit objectives, i.e. exert minimal interference with market mechanisms, be theoretically sound, be simple to understand, compute and implement, be based on accurate and reliable risk data; impose minimal additional reporting and compliance costs, be efficient, and minimize the need for supplementary nonprice regulation. for depositors to monitor the depository institutions in which they place their money. Only the US, Marshall Islands, Micronesia and Argentina since 1995 use a risk-sensitive premium system. Thirty-five countries use a flat-premium system with premium charged on deposits ranging from 0.0125 in Japan to 0.94 in Nigeria. Deposit insurance with a flat-rate premium alone may not cause bank failures. Some scholars offer other causes for an increasing number of bank failures in the US. For example, Schwartz 1987 states that the recent problems of the US banks are due more to inflation instability and the consequent interest rate instability, than to deposit insurance. Keeley 1990 attributes the recent increase in bank failures in the US to lower capital-asset ratios caused by declining bank charter values. This decline is triggered by increased competition faced by commercial banks. Other causes of bank failures include poor management, infrequent and lax bank examination. The Basle Capital Adequacy Ratio, implemented in 1993 in many countries, may lessen moral hazard on the part of depository institutions. If necessary, additional measures to restrict and penalize banks’ excessive risk-taking behavior may be imposed under a flat-rate deposit premium system. Recently, scholars such as Nagaragan and Sealey 1995 p. 1100 have argued that ‘‘even flat-rate deposit insurance can be optimal when combined with a sound forbearance policy and a minimum capital standard’’. The appropriateness of a flat-rate premium structure should be evaluated with reference to the existing regulatory framework of a country. Usually, implicit premium mechanisms within a regulatory system may reduce the moral hazard associated with deposit insurance. For example, potential financial losses of a bank may curtail the risk-taking incentive of bank management. Bank management may also exercise self-constraint in order to avoid the damage to their careers in case of bank failures. 6 . 4 . Basis for premium assessment Deposit insurance premiums can be assessed on either total deposits or insured deposits. Alternatively, assessments can be based on, for example, average monthly or quarterly deposit balances during a certain period, rather than on balances as of a given assessment date. To prevent switching of insured deposits to uninsured deposits at the end of the year, premiums should be charged on total deposits. Switching deposits is a real possibility if insurance premiums are charged only on year-end insured deposits. Applying the same premium rate to all depositors is administratively simpler but involves cross-subsidization. Some may argue that charging premiums on total deposits instead of on insured deposits is not fair to depositors with deposits exceeding the protection limit. This is particularly unfair to large banks, as they may have a greater number of large uninsured depositors 20 . However, we should not ignore the fact that large banks, are less likely to fail because they can more 20 This argument against using total deposits as the assessment base may not apply if the protection ceiling is discretionary or protection is extended to all depositors. easily obtain financial support from the government. As referred to above, deposits with foreign banks located in the home country are usually not subject to insurance premiums, which puts the large banks on an equal footing with their smaller counterparts. Table 4 shows that 28 countries assess their premiums on total deposits while 10 countries set their premiums only on insured deposits. In Norway and Finland, premiums are set on banks’ assets. In Korea, Sweden and Italy, premiums are directly or indirectly related to banks’ assets. Such an approach was acknowledged by the FDIC as a substantial departure from tradition without any direct relation- ship between assessed items and those items insured 21 . Insurance premiums should not be charged on bank assets, as only bank deposits are protected. Furthermore, liquidity and diversification of assets are more relevant than just absolute value of assets as a measurement of bank risk. 6 . 5 . Contingency funding arrangement The adequacy of the deposit insurance fund depends on four major cash flows, namely premium payments, investment income, claims payments, and administra- tive expenses. Of these, the insurance fund has some control over the premium payments and administrative expenses. Of course, the fund has no control at all over investment income and claims payments. Therefore, it is difficult to predict the amount of funds that would be sufficient to meet any claims made upon the deposit insurance agency 22,23 . According to a survey by the Canada Deposit Insurance Corporation 1993, there exists no formal mechanism to determine the size of deposit insurance funds. Only six countries out of a total of 20 countries responding to the survey, have a target fund size. Both the UK and Denmark have a minimum target fund size. In the other four countries, target fund size ranges from 0.5 of insured deposits in India to 1.5 of total assets in Norway. As Dale 1984 reports, the size of insurance funds, relative to the insured deposits, varies considerably among coun- tries i.e. about 1 in the US and 0.067 in Japan. In countries outside North America, funds are maintained at a significantly lower level. Benston 1983 does 21 ABA 1995, p. 10. 22 According to Tally and Mas 1992, one way to structure financing of a deposit insurance system is to set a target range for the fund’s capital ratio i.e. capital plus reserves to insured deposits, and then overtime, and maintain the fund’s actual capital ratio within that range. Besides capital injection, the size of the fund depends on four major cash flows. 23 Wall 1997 proposes that to improve monitoring of the deposit insurance fund, the FDIC may consider issuing capital notes to private investors. The promise of payment is contingent on the state of the insurance fund. This capital note proposal gives investors an incentive to examine the fund, as well as a mechanism for expressing their views. Capital notes would also help regulators by providing an independent assessment of the risks facing the fund and by enhancing the incentives of senior regulators to protect the fund. not regard insurance fund size as the key to maintenance of the public’s confidence in the deposit insurance system. ‘‘The fund itself is irrelevant, and the ultimate guarantor is the US Treasury, whose resources are inexhaustible’’ p. 20. Bal- tensperger and Dermine 1986 p. 78 also regard the size of the insurance fund as ‘‘…a rather meaningless number, … as the insurance fund must be seen in relation to potential payouts and the possibility of raising additional funds.’’ There is always a risk of a funds shortage particularly for a new scheme. Contingency funding measures for dealing with situations where the accumulated resources of the DPS are inadequate are an essential part of a DPS. Table 5 shows different measures adopted in different countries. First, the protection ceiling can be limited to the available resources of a DPS, even though it has guaranteed deposits up to a specified amount. This measure is adopted in Iceland and Ireland. Second, as in the case of Belgium, the level of coverage can be reduced if assets are inadequate to meet the claims. This adversely undermines public confidence and renders the DPS ineffective in preventing bank runs. The third measure, used in Italy, is to defer the payment of claims. This option is better than the first two, but the slow payment of claims runs contrary to the original objective of a DPS. The uncertainty of when protection is available to depositors could reduce public confidence in the DPS. The fourth measure is to make advance calls on insured banks in order to make additional premium contributions. This could create an uncertain financial burden on banks. Making advance premium calls on participat- ing banks is the primary measure of contingency funding in France, Germany, Luxembourg, Oman and the UK. Last but not least, a DPS may be allowed to borrow either from the government or from the public. From the depositors’ point of view, government support would be ideal. Tally and Mas 1992 conclude that one of the basic requirements for the success of a DPS is that the government should exhibit a willingness to adequately fund a DPS and give it necessary backup to get the system through a period of stress 24 . Government support is necessary particularly during the transitional period when a fund has not yet accumulated sufficient resources. Experience suggests that government support is necessary to secure the confidence of depositors. Financial support from the government, as a contingency funding option, is adopted in 16 countries including Austria, Canada, Denmark, India, Japan, the Netherlands, Norway, the Philippines, Spain, the UK and the US.

7. Summary and conclusions