21 argue that ‘‘…if foreign deposits were assessed, US banks would bear the cost directly. This would force these banks out of major wholesale markets abroad, with
adverse effects on them and on the US’s role in the international economy’’. Nasser 1989 shares this view and reports that assessing premiums on foreign currency
deposits may induce substantial cost and therefore jeopardize the competitive positions of large US banks vis-a`-vis their foreign competitors
8
. He therefore concludes that, with the internationalization of the banking business in the last
several decades, this issue has become one of the more controversial topics dividing bankers
9
. This remark is perhaps of special significance to those countries with international financial centers. Another risk that arises from not protecting foreign
currency deposits is the limited and partial protection to depositors, and conse- quently the threat to banking stability.
To arrive at a proper decision, a country should take into account the deposit structure, the primary objectives of a DPS, and interest differential between
domestic and foreign currency deposits. If the majority of deposits in a country are in foreign currencies and the primary objective of a DPS is to prevent general bank
runs, then there is a strong argument for protecting foreign currency deposits. For those countries with high interest differentials between local and foreign currency
deposits, the need to protect foreign currency deposits is less strong, as the foreign currency deposits are more investment-oriented.
Table 3 shows that currently, 14 countries confine protection to deposits in their local currencies only. Thirty one countries protect both domestic and foreign
currency deposits. Information is not currently available for the remaining six countries.
5. Level of protection
5
.
1
. Full 6s partial protection To gain the full benefit of a deposit insurance scheme, the extent of protection to
depositors should be to achieve its objectives without inducing significant moral hazard. Fig. 2 presents the interrelated issues and problems connected with the
decision on the extent of protection. To Fry et al. 1996, full protection, or the American approach, is urged on the
grounds of greater efficiency and equity. Another merit of full coverage is that it lowers the depositor’s incentive to withdraw funds from financially troubled banks
and permits a bank to weather storms more successfully. It also enables the authorities to handle cases with greater ease. If the primary goal of deposit
8
This is also the reason why the US Congress deliberately excluded deposits at foreign branches from the deposit insurance assessment base. See Huertas and Strauber 1986.
9
The pros and cons of excluding foreign deposits from the deposit insurance assessments are analyzed in Nasser 1989.
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41 Table 3
Level of protection
a
US equivalent Protection of local cur-
Country Level of protection
rency only Argentina
100 of less than A 100 mn; 90 of deposits over A 10 000 for deposits up to 90 days, 20 000 for de- No
posits exceeding 90 days. Basic guarantee 3000 100 mn
No Sch 200 000 of savings deposits
17 030 Austria
Yes Tk 60 000
1500 Bangladesh
BFr 500 000, limited to assets available Belgium
14 500 before Dec. 31 1999, ECU 20 000 after Dec. Yes, including any cur-
rency of the EU 31 1999
Yes C60 000
43 430 Canada
3000 100 month variable tax units, 100 for demand de-
No Chile
posits; 90 for time deposits, up to Ch120 per year No
Columbia 75 of total or Col. 10 million
12 000 3565
80 of deposits up to a limit of Kc 100 000 Czech Republic
No No
DKr 250 000 39 330
Denmark 100, maximum RD8000, restricted to savings and
8000 Dominican Re-
No public
fixed term deposits No
C300 000 3400
El Salvador No
Finland Full
Full Yes
FFr 400 000 71 060
France Germany
Up to 30 of bank’s capital equity Up to 30 of bank’s equity capital per depositor
No ECU 20 000
NA 17 160
Greece No
Ft 1 mn 8300
Hungary Full coverage up to 80 for deposits with commercial NA
Iceland No
banks and 67 for savings banks No
Rs 30 000 975
India From 7940 to 15 885
80 of first Irish £5000; 70 of next 5000; 50 of Yes
Ireland next 5000 maximum Irish £10 000
No 120 000 to 170 000
100 on first Lire 200 mn; 80 of next Lire 800 mn, Italy
any portion of deposits in excess of Lire 1 billion are not protected
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42 Table 3 Continued
Protection of local cur- Level of protection
Country US equivalent
rency only 80 800
Yes Japan
Yen 10 mn; principals only Kenya
KSh 100 000 No
2100 Korea
NA US27 000
W20 mn Full
No Full
Kuwait Lebanon
Li 30 000 No
18 No
Lux F 500 000 14 500
Luxembourg Marshall Islands No
100 000 US100 000
Full No
Full Mexico
Micronesia US100 000
No 100 000
Netherlands Fr 40 000
No 21 320
2270 N 50 000
Nigeria Yes
Norway No
Nok. 2 mn NA
Oman NA
Ro 20 000 or 75 of the net deposit; whichever is less NA
G 5 mn Yes
4800 Paraguay
No S 4600, indexed to inflation
2100 Peru
3700 Philippines
Peso 100 000 No
US1340 plus 90 of all funds deposited up to a NA
4020 Poland
maximum of 4020 100 up to set limit, then co-insurance 75, 50 is
No NA
Portugal applied
Pta 1.5 mn No
10 580 Spain
NA SKr 250 000 including accrued interest
7000 Sweden
Switzerland No
20 825 SF 30 000
NT1 mn Yes
36 330 Taiwan
Tanzania T Sh 250 000
Yes 480
Yes TT 50 000
8500 Trinidad and
Tobago 83
TL 3 mn 100 coverage provided in April 1994 Turkey
No Yes
USh 3 mn 3000
Uganda Yes
75 of deposits up to £15 000 per depositor 24 638
UK 100 000
US100 000 US
No Venezuela
Bs 4 mn Yes
23 600 Yugoslavia
No Full
Full
a
Note: Details not available for Brazil. Exchange rates against US on 2 April 1997. 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.
Fig. 2. Determination of the level of protection.
insurance is to protect small unsophisticated depositors, as many have suggested, the protection limit does not need to be full. Full protection is preferred from a
stability point of view, as it is especially effective in preventing over-reaction to groundless rumors by smaller unsophisticated depositors. Full protection can also
reduce depositors’ needs to monitor behavior of their banks.
It can be counter-argued that even with full coverage of deposits, depositors still have every incentive to remove deposits from a failing bank due to the inconve-
nience and temporary liquidity problem associated with having deposits blocked and having to wait for repayment. Therefore, even full protection reduces, but does
not eliminate, the motivation for a run on a bank.
Partial protection may potentially cause bank runs. The greater the degree of co-insurance, the higher the likelihood that the uninsured will participate in a run
at the first hint of unfavorable news about their banks. Therefore, partial protection
is against the objective of stability in the banking system, which is one of the major reasons for deposit insurance.
The major rationale behind the proposal for not providing full deposit protection is to reduce the extent of moral hazard on the part of both depositor and
depository institution. Therefore, Hoskins 1990 advises that ‘‘to truly reap the benefits of deposit insurance reform in the US, the current statutory limit
US100 000 should be reduced, and co-insurance should be made available for coverage on balances that exceed the limit’’. To us, the high and comprehensive
protection of the US deposit insurance scheme may be the root cause of the current problems in that country’s deposit insurance
10
. Baer and Brewer 1986 support their view that uninsured depositors are an
important source of market discipline with empirical evidence from the certificates- of-deposit market. In a co-insurance system, a price will be attributed to the risk of
bank borrowing by the interest rates prevailing in the market. It is questionable whether market discipline from the depositors who are partially
protected is reliable. It should be noted, however, that the difficulty to judge the financial condition of intermediaries, coupled with low level of financial sophistica-
tion of the typical depositor, may make market discipline by depositors an unfair and inefficient way to ensure prudent investments by financial institutions.
Ely 1986 points out an important fact that depositor monitoring is not reliable, as depositors are creditors and they have no upside disciplinary incentive, such as
the opportunity for higher interest rates or principal appreciation. Instead, they run at the first sign of bank trouble. Furthermore, those who consistently and aggres-
sively monitor their depository institutions are the first to run. To test whether market discipline anticipates banks’ downgrade to problem bank status, Simons
and Cross 1991 employ residual analysis. Again, their results cast doubt on the supposed advantages that investors, and especially uninsured depositors, would
have over bank regulators in restraining risk-taking by banks and in monitoring their management. Therefore, market discipline associated with co-insurance may
not necessarily lessen the need for regulation.
On the decision of whether to provide full or partial protection, one has to take into account several considerations. First, if the primary objective of a DPS is to
prevent system-wide bank runs, then protection should preferably be full. As Baltensperger and Dermine 1986 remark, the ‘small deposit’ criterion can be
questioned if the objective is to protect the less-wealthy depositor. Income or wealth criteria may be more appropriate as the basis for premium assessment. Second,
partial protection reduces the moral hazard impact, but the existence of effective explicit and implicit mechanisms within the banking system can help minimize the
moral hazard problem even if protection is close to full. Third, ready availability and greater efficiency of the lender of last resort facilities and regulation and
supervision place less reliance on a DPS as a means to prevent general banking
10
To us the protection in the US is too high because protection coverage has increased by 40 times since the introduction of Federal Deposit Insurance on 1 January 1934 from US2500 in 1934 to
US100 000 in 1980. In contrast, over the same period, prices have increased only by about eight times.
instability. In such a case, full deposit protection is less relevant. These two factors were highlighted by Tally and Mas 1992 as aspects that policymakers should
consider when weighing the pros and cons of alternative coverage arrangements
11
. Fourth, full or partial protection, with the resulting amount of premiums charged,
has an implication on the burden to the deposit insurance fund and the bearing of costs to the depository institutions or depositors. Fifth, the extent of protection to
depositors depends on the extent of market discipline desired. Sixth, the availability of other channels of safe investment to small depositors may lessen the need to
protect naive small depositors through a DPS. Finally, the protective ceiling also depends on the reliability of market discipline from the uninsured depositors and
other bank creditors.
Table 3 shows the protective ceilings in 51 countries. Currently, only four countries, Finland, Kuwait, Mexico, and the former Yugoslavia, provide unlimited
or full deposit insurance protection.
5
.
2
. Rationale for protection ceiling As full insurance undermines market discipline, it is frequently argued that there
should be a ceiling on deposit insurance. If protection is not full and market discipline from uninsured depositors is not always reliable, what should be the
cut-off line and how can we determine the percentage of maximum protection? Several proposals have been put forward to answer these questions.
From Fig. 2, we can see that if the main objective of deposit insurance is to enhance the stability of the banking system, it is more appropriate to base insurance
coverage mainly on terms of maturity, with short-term deposits receiving insurance coverage. Regarding the definition of short-term deposits, Furlong 1984 advises
that the deposit maturity chosen should allow an adequate period of time for evaluating the financial condition of banks.
Both Benston 1983 and Furlong 1984 recommend that all liquid deposits should be insured while those relatively illiquid ones should remain at risk. Kane
1986 also suggests that ‘‘authorities should investigate the effects of relating progressive declines in coverage directly to account size or interest rates and inversely
to an account’s maturity’’ p. 184. It is hoped that in this way the uninsured depositors will not have the incentive to withdraw their assets. The rationale for this
proposal is that short-term or demand deposits typically constitute the major source of a bank run. This recommendation has several merits. It is obviously consistent
with the classic deposit insurance objective of avoiding the cost of a bank run while encouraging banks to take fewer risks. Since the mismatch of asset and liability
duration is a source of banking instability, linking deposit protection to deposit maturity may encourage depositor discipline on a bank’s risk-taking attitude.
11
Tally and Mas pointed out that some American scholars have argued that deposit insurance is not needed to prevent bank runs because an effective lender of last resort can handle such runs if they occur.
However, this view is based on the assumption that bank runs take the form of deposit transfers from weak banks to strong banks. But things may not work out as smoothly as assumed.
However, Carns 1989 states several problems connected with the adoption of a maturity-based insurance scheme. First, he points out the lack of a proper defini-
tion of short-term maturity deposits. The sensitivity to bank runs varies even for deposits of the same maturity. Second, short-term deposits are usually of smaller
amount as they carry lower interest rates. Third, to ensure that short-term depositors do not withdraw their deposits early, the penalty for doing so must be
sufficiently high. The final, and indeed the most important problem, is caused by possible maturity switching over time. This would render the whole scheme
ineffective and result in undesirable resource allocation in the economy. Carns 1989 accordingly warns that there may be some intervention in the financial
market as a result of the change in the deposit structure due to the switching of deposits. Moreover, no concrete evidence supports the view that runs are often
initiated by withdrawals of demand deposits.
According to the Canada Deposit Insurance Corporation 1993, current, savings and time deposits are covered by most deposit insurance schemes. Savings deposits
are only protected in Switzerland and Turkey; wage accounts are also protected in Switzerland. In Chile, demand deposits are fully protected while savings deposits
are protected up to 90. Unfortunately, further information on deposit insurance based on the maturity of deposits is not available for comparison.
Fig. 2 shows that a variation of the above approach is a legislatively mandated co-insurance provision, based on deposit size, as the one currently used in the UK.
Such a mechanism was proposed as a market-based incentive to reform the deposit insurance system in Canada Gordon, 1994. Under such a scheme, deposit
balances are fully insured up to a maximum amount, with balances above this limit subject to a reduced level of coverage. Depositors of amounts exceeding the fully
insured ceiling can ‘co-insure’ the excess deposits. Goodhart 1988 is in favor of such a partial protection system
12
. However, Hall 1988 warns that in the UK, the degree of risk the depositors are asked to assume 25 is too high if banking
stability is the prime objective of deposit insurance. Several problems plague the implementation of co-insurance that is based on
deposit size. There is the possibility of bank runs and their contagion effects as a result of withdrawals by large risk-averse depositors. Some of the uninsured
depositors may simply withdraw their deposits rather than wait to get their accrued interest at the maturity of their deposits. The uninsured depositors may not be
attracted by the higher interest rate offered by their banks because the cost of a potential loss may be too high in the event of a bank failure. This is complicated
by the fact that many large depositors are also more knowledgeable and better informed about the credit-worthiness of their banks, and thus may withdraw their
deposits at the very first sign of problems. Some of the uninsured deposits may be of short-term nature and that they can easily be withdrawn at the first sign of
trouble.
12
This is consistent with his suggestion for other countries. See Goodhart 1988, p. 49.
Effective implementation of co-insurance, no matter which format is adopted, is very difficult, if not impossible. Although coverage is applied on a per depositor per
bank basis, loopholes to circumventing such rule exist. A depositor may hold accounts under different names within a single bank. If the objective of a DPS is to
protect small depositors rather than prevent system-wide bank runs, inter-bank deposits should be excluded from protection coverage. From Table 2, we can see
that this is practiced in 32 countries. Inter-bank deposits are only covered in nine countries including Kuwait, Peru, the US, Trinidad and Tobago.
5
.
3
. Le6el of protection ceiling If we are in favor of some kind of co-insurance or partial protection, our next
task is the determination of the protection ceiling. This is necessary as we have to keep the costs of a DPS within affordable limits and at the same time ensure that
the major benefits go to small depositors. Such objectives cannot be easily achieved, as we cannot assess the wealth of depositors merely on the basis of their deposits
in a single bank, unless the protection is on a per depositor per bank basis. The ceiling that is too low increases the number of depositors at risk and, therefore,
these depositors are more likely to exert market discipline on their banks. On the other hand, if the ceiling is too high, it enables more depositors to enjoy greater
protection but with a greater degree of moral hazard. Therefore, Dreyfus et al. 1994 assert that the choice of a cap on insured deposits does not need to be trivial.
Their study shows that a liability less than that calculated on an actuarial basis by the insurer will affect the probability that a bank will be optimally closed by the
insurer. Dreyfus et al. 1994 warn that if the insured ceiling is set ‘too low’, a bank may be unable to pay the interest rate or risk premium required by uninsured
depositors. As a result, the bank will have to be closed.
According to Walker 1994, the primary cause of the financial distress of US thrift institutions that failed in recent years appears to be the increase in the deposit
insurance limit to US100 000. Consequently the FDIC has considered the possibil- ity of curtailing the scope of deposit protection to improve market discipline
13
. However, some other countries are moving in the opposite direction. The EU has
proposed to extend the scope of deposit protection within its member countries, and has raised the limit on the coverage from 15 000 to 20 000 ECU
14
. Dale 1993 contends that the idea of depositor protection and the simultaneous restriction of
that protection are paradoxical. Of course, any limit on the ceiling of protection would be irrelevant if depositors
could make use of loopholes in the scheme by establishing separately insured deposits in the names of various household members. The opportunistic use of
other means, such as partnerships and nominee companies, to obtain multiple coverage must be strictly forbidden.
13
See Di Nuzzo 1991, p. 10.
14
See European Commission 1993, p. 8.
Table 3 shows the protection ceilings in 51 countries. Currently, only four countries, Finland, Kuwait, Mexico, and the former Yugoslavia, provided unlim-
ited or full deposit insurance protection. As it is not always possible to protect all deposits, the scope of any deposit insurance should be limited in one way or
another. However, several patterns can be grouped for discussion. First, for those countries with partial protection, the protection ceiling ranges from 50 to 90 on
all deposits. Second, many countries such as Italy, Argentina, Chile, Iceland, Austria, Canada, Denmark, France, Greece, Luxembourg, the UK, Taiwan and the
Netherlands adopt a tiered approach and give full protection up to a certain limit, with excessive deposits subject to co-insurance. Thirty-six countries provide full
protection for deposits below a certain amount, ranging from US200 in Lebanon to US170 000 in Italy. Any deposits exceeding the limit are at risk. Third, the
extent of protection can be based on the type of deposit. In Chile, protection is full for demand deposits but savings deposits are protected only up to 90. Informa-
tion for the remaining four countries is not currently available.
Indeed, the only way to really accomplish the objective of deposit insurance is to restrict the maximum amount of protection available to one person from all
depository institutions. With the extensive use of computers nowadays, such a rule can be implemented easily in many countries.
5
.
4
. Incenti6e-compatible protection ceiling In order to reduce the moral hazard and to encourage banks to provide
information to the deposit insurance agency for premium assessment purposes, it has been proposed that deposit insurance should be voluntary. The incorporation
of a certain element of voluntarism into the amount of deposit insurance has been proposed in the literature. A simple way is to provide banks with an option of
securing additional protection for their depositors. Kane 1986 proposes the extension of the optional insurance to depositors themselves. A scheme which
allows a depository institution to choose its preferred combination of capital requirements that are inversely related to deposit insurance premiums is suggested
by Chan et al. 1992. Fan 1995 proposes a deposit insurance scheme which allows a depositor to choose either ‘full’ or ‘partial’ insurance from the deposit insurance
fund. If a depositor chooses to be ‘fully’ insured, he will have to forgo some of the interest on his deposit in order to pay for the cost of deposit insurance. If a
depositor buys ‘partial’ insurance, he earns the market interest rate from his deposit when his bank is sound, but he will be fined if his bank goes bankrupt or fails to
meet specified criteria. In this proposal, a depositor can change his form of insurance at any time. The main defect of this proposal is that the incentive to earn
the market rate may not be strong enough for a depositor to maintain his deposits when his bank runs into trouble.
The idea of voluntary deposit insurance sounds good, but all voluntary schemes are fraught with practical difficulties. The fundamental problem is the ‘free-rider’
effect of deposit insurance — a public good. If a bank has low risk, both depositors and bank would not have a strong incentive to purchase deposit insurance.
6. Funding of the deposit insurance scheme
