mechanisms are complementary to each other and are collectively known as the safety net in a banking system.
Although the concept of deposit insurance is quite simple, deposit insurance systems are relatively complex mechanisms. When designing a deposit insurance
system, one has to grapple with a sizable number of complicated issues, some of which are not easy to resolve. The special banking environment of the country
proposing to set up a DPS has to be taken into account at the design stage. Evidence from countries with deposit insurance shows that no DPS can be perfect.
Most of the existing literature on deposit insurance tends to be overly confined to a discussion of the reform proposals and risk-related premium assessment method-
ologies. The theoretical explanation of the alternatives to the major components of a deposit insurance scheme is sketchy. Comparisons on the international practice of
deposit insurance are not extensive and comprehensive enough. Furthermore, advice on the design of a complete deposit insurance scheme is literally absent. To
fill the gap in the literature, this paper examines the theoretical foundations of the key issues of a deposit insurance scheme, provides a critical comparison on the
international practice of deposit, and makes suggestions on how a complete deposit insurance scheme can be designed and implemented properly.
In this article, we will first state the unique role of deposit insurance. This is followed by a detailed discussion of each of the alternatives of the major features
of a DPS including administration, coverage, protection ceiling, financing, premium assessment and contingency measures. Reference will be made to international
practice wherever possible. A summary of recommendations regarding the design of a DPS will be given at the end.
2. Rationale for deposit insurance
According to Fama 1980, banking is different from other types of business. Diamond 1984 has developed a theory of financial intermediation to show that
banks are unique as they enhance social welfare by funding illiquid assets with very liquid liabilities. Diamond and Dybvig 1983 have further shown that the liquidity
transformation that enables banks to provide useful services is also a source of their susceptibility to disruptive deposit runs. Friedman 1962 has convincingly re-
marked that a fractional reserve banking industry is ‘inherently unstable’ in the sense that no bank, however soundly managed, can withstand a sustained run
without governmental intervention or an organized rescue operation by other banks. Bank runs are contagious and the most pernicious effect of a panic is that
it may result in the closing down of sound financial institutions along with the unsound. In light of the vulnerability of banks, deposit insurance has a vital role to
play.
Before we review the theory and practice of deposit insurance, we must begin by enumerating the unique goals of a DPS. First, deposit insurance can protect
unsophisticated small investors. Second, deposit insurance safeguards individual banks. Third, deposit insurance can also safeguard the banking system by prevent-
ing runs on depository institutions. Finally, deposit insurance promotes fair compe- tition in the banking industry. On the other hand, there are arguments against a
DPS for the reasons that they are expensive, unnecessary, ineffective or impractical in some countries. If a DPS is properly designed, most of the undesirable effects
will be greatly minimized if not completely eliminated. Therefore, it is hardly surprising that there is almost unanimous advocacy for deposit insurance in
developing countries by the IMF, the World Bank and other such policy advisors McKinnon, 1991.
Most advanced as well as some developing countries have created a DPS of one form or another. Currently, we are aware of 51 countries that have set up their
DPSs. Another 20 countries either intend to have or are making preparations for a DPS. Out of these countries, four have drafted their DPSs
3
. In the next few sections, we shall discuss the components of a DPS in detail. For easy of reference,
these major components are summarized in the bottom half of Fig. 1.
3. The administration of deposit insurance
