Monday, Apr 24, 2023
A Toolkit for Developing a Deposit Insurance Scheme
ABSTRACT
The toolkit is intended to be a resource for prospective and existing deposit insurers in developed and developing countries, as well as other participants in a country’s financial safety net.
This Toronto Centre Toolkit was prepared by Claire McGuire and John O’Keefe. Please address any questions about this Toolkit to This email address is being protected from spambots. You need JavaScript enabled to view it.
TABLE OF CONTENTS
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Crisis Management and Resolution Issues Affecting the Deposit Insurer
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Templates of Deposit Insurance Laws, Operations, Policies and Agreements
Bank deposit insurance can be an important part of a country’s financial sector safety net and, as a result, deposit insurance schemes have been adopted by a large number of countries. The purpose of this document is to provide a toolkit for the establishment and further development of deposit insurance schemes. The toolkit is intended to be a resource for prospective and existing deposit insurers in developed and developing countries, as well as other participants in a country’s financial safety net. The toolkit includes: 1) a guide for the development of a deposit insurance scheme, 2) templates for legislative, legal, and organizational documents (e.g., deposit insurance laws, organizational charts, corporate governance policies, crisis management plans), and 3) analysis tools for determining insurance premium systems, premium rates, and the target insurance fund. Templates and analysis tools included are embedded documents and, where necessary, as internet links to materials.
The deposit insurance guide included in this document discusses aspects of deposit insurance scheme design from three perspectives. The first perspective is the legal basis for the insurer (i.e., a Deposit Insurance Act or equivalent legislation establishing a deposit insurance scheme) that, in turn, determines the insurer’s mandate and powers (e.g., failure-resolution methods, reimbursement of insured depositors, failed-bank receiver/liquidator, levy assessment/premium setting, bank regulation, access to supervisory information and access to insured banks) and responsibilities for day-to-day operations and financial crisis management. The second perspective is the design of the deposit insurance framework (e.g., coverage, claims priority and insurance premiums (assessments)). The third perspective is the organizational design and governance of the deposit insurer that is determined by the previous two design factors, as well as by the underlying economic, governmental and legal systems. The guide draws from recommendations provided by the International Association of Deposit Insurers, International Monetary Fund, World Bank Group, the Financial Stability Board, European Commission, national public sector bank regulators (e.g., Bank of England, U.S. Federal Deposit Insurance Corporation) and academic research.
OPERATIONAL ASSUMPTIONS
The Toolkit is designed for a deposit insurer that operates under a “paybox-plus” model, which is the most common model worldwide. Such a model represents a practice that allows a deposit insurer to contribute to resolution actions and thus provide the resolution authority with a greater ability to implement a cost-effective resolution and avoid the disruption of a liquidation action often at a lesser cost. In general, however, each jurisdiction should select a deposit insurance model that best suits their legal, economic and regulatory environment.
In preparing this guide we assumed the following: 1) the deposit insurer is an independent agency of the national government, and 2) co-insurance of deposits is not available. Should these assumptions not hold true, the recommendations provided by this guide and toolkit may have to be modified to fit the individual country’s framework. The toolkit can be applied to deposit insurance schemes for any type of depository institution—e.g., commercial banks, specialty banks, savings associations and credit unions—which we refer to as banks in this document.
TARGET AUDIENCE
The Guide and Toolkit can be used as starting points for deposit insurers that wish to develop the appropriate forms, agreements and Memoranda of Understanding to improve their operations and make deposit insurance more widely known and understood in their jurisdictions or as a way to amend forms and agreements already in existence. The outline of the Guide and Toolkit largely draws from the governing principles for deposit insurers set forth in the International Association of Deposit Insurers Core Principles for Effective Deposit Insurance Systems, and practices recommended or applied by the aforementioned international and national organizations concerned with deposit insurance as well as academic research.
2. INITIAL CONSIDERATIONS FOR INSURANCE SCHEME DESIGN
The strengths and weaknesses of deposit insurance schemes can be traced to scheme design and how that design aligns with public and private sector institutions as well as legal and regulatory systems in the jurisdiction. In this section we review the origins of deposit insurance from historical and theoretical perspectives.
2.1 HISTORY, BENEFITS, AND COSTS OF DEPOSIT INSURANCE
Banks have existed since medieval times (e.g., Medici Bank of Florence in the 1400s) and banking services can be traced to the Roman empire. Despite the early origins of banking, deposit insurance is a relatively recent phenomenon. The first deposit insurers in the U.S. appeared in the 1880s as state- sponsored and private systems; all these early deposit insurers failed. Czechoslovakia was the first country to establish a national deposit insurer in 1924.The United States was the second country to establish a national deposit insurer, the Federal Deposit Insurance Corporation (FDIC), in 1933 as part of the New Deal economic support programs enacted after the U.S. Great Depression. This history raises questions about why it took so long for deposit insurance to appear compared to banks and why did government support deposit insurance spread globally in the latter half of the 1990s and early 2000s?
A key to understanding deposit insurance is to compare its history to that of other types of insurance, such as fire, property, and life insurance. The first property insurers in the United Kingdom that insured merchandise and ships appeared in 1601. The types of insurance available in the United Kingdom expanded over time to include fire insurance in 1666. Life insurance was first offered in the United States in 1759. There are important differences between fire, property and life insurance versus deposit insurance that help explain the late development of deposit insurance. The first difference is that insurance contracts for fire, property, and life insurance cover physical objects where loss usually occurs due to independent events. Under these circumstances, actuarial science can devise contracts that are both affordable to the insured and profitable to the insurer. Should large-scale events occur that trigger widespread claims and insurer losses, the insurer will most certainly fail but such events are historically rare (e.g., severe weather causing fire, flood, and loss of merchant ships). Importantly, both the insurer and insured have knowledge of the underlying risks and rewards of the insurance contract, i.e., there is less opportunity for adverse selection than occurs with deposit insurance. Fire and property insurers can inspect the property and learn its true market value. Further, the insurance contract can include conditions that nullify the contract should there be fraud on the part of insurance claimants. This is very different from the situation created by national deposit insurance where insured depositors only have access to aggregated bank financial data—income statements and balance sheets—and whatever information bank supervisors might provide (e.g., in the U.S. supervisory enforcement actions against banks that violate laws and engage in unsafe and unsound practices).
In addition, with fire, property and life insurance there is less opportunity for moral hazard than occurs with deposit insurance. Specifically, moral hazard in deposit insurance is the reduced incentive of insured depositors and bankers to monitor risk due to the insurance provided. Moral hazard in banking is encouraged by the implicit or explicit guarantee of the national government that accompanies the deposit insurance offered to depositors. A merchant shipping company will have less opportunity to defraud the insurer if the insurer can inspect cargo and vessel. This is very different from the situation insured depositors and bankers face where insured depositors have little incentive to monitor the bank’s risk of illiquidity and insolvency. Further, bank management typically has little financial stake in the bank but can extract substantial wealth through salaries, bonuses, and severance packages even while making negative net present value investments for the bank.
Regarding fire, property, and life insurers, we should ask who monitors their condition? These types of insurers rely primarily on premiums from insured customers for funding and these customers have reason to monitor insurers’ ability to perform on the contract. Further, jurisdictions establish insurance regulators to oversee insurance companies’ activities and monitor their condition, and also establish guarantee funds that provide financial support for customers of failed insurance companies. To conclude, the prevalence of adverse selection and moral hazard in deposit insurance suggests deposit insurance is not a profitable private sector enterprise and a risky public sector enterprise; we explore these issues further in the next section.
2.2 ADVERSE SELECTION AND MORAL HAZARD IN DEPOSIT INSURANCE
Calomiris and Jaremski review the extensive literature on deposit insurance and state that the spread of deposit insurance can be explained by two alternative theories. The first is the traditional economic rationale for deposit insurance as a means of limiting bank runs. To begin, consider the causes of bank runs. Individuals find the maturity transformation function banks provide to be beneficial. Small depositors are generally unable to monitor the use of credit they might provide directly to firms and other individuals, as well as indirectly through banks, due to the high costs of monitoring those obligors. Individuals do, however, value the use of bank deposit accounts for transactions and are willing to lend to banks (deposit accounts) and delegate the monitoring of the ultimate borrowers (bank loans to businesses and individuals) to banks. Bank lending becomes less risky as the scale and scope of lending increases due to the diversification of loan portfolios, all other factors being equal. Banks are still exposed to losses due to credit cycles where credit risk cannot be sufficiently reduced through loan portfolio diversification to limit the risk of bank insolvency.
Whether due to macroeconomic conditions or idiosyncratic bank problems, some bank depositors will find reason to withdraw deposits when perceived bank illiquidity and/or insolvency risk is high and not wait until banks become illiquid and/or insolvent before doing so. Large-scale withdrawal of deposits can lead to severe illiquidity at a bank (liquidity insolvency). Depositors are aware of the “first come, first serve” reality of deposit withdrawals and this can precipitate widespread withdrawals of deposits (i.e., a bank run). Further, a run on one bank can lead to runs on other banks perceived to be in the same position as the initial bank, broadening the crisis. Bank runs have occurred historically with banks lacking deposit insurance, most prominently in the U.S. in 1929, resulting in the Great Depression. Bank runs have also occurred with banks that offered relatively limited deposit insurance. The United Kingdom bank, Northern Rock, experienced a bank run in 2007 when the public became aware of its severe illiquidity due to losses on subprime real estate loans. At the time of the run on Northern Rock, UK’s deposit insurance covered 100 percent of the first £2,000 of deposits and 90 percent of the next £33,000 in deposits, resulting in a maximum coverage level of £31,700. The 2006–2007 average income in the U.K was £23,325; it is likely that many individuals had deposit balances above £2,000 at Northern Rock and would likely lose money should the bank fail.
Deposit insurance can greatly reduce the risk of bank runs if the insurance is credible and coverage is sufficiently high. Calomiris and Jaremski point out that the economic benefits of deposit insurance come at a cost—reduced market discipline. The fact that many bank creditors have less need to monitor banks’ condition when deposit insurance is provided can result in increased risk tolerance by bank managers, senior executives and boards of directors. Reduced incentives to monitor risk by bankers and insured depositors is the moral hazard problem of deposit insurance. The moral hazard problem is compounded by a second problem in banking, adverse selection. The fact that depositors find it costly to monitor banks and those to whom banks lend means bank borrowers and bank management have an information advantage relative to depositors. Historically, bankers and bank borrowers have used that advantage to their benefit at the cost to depositors and deposit insurers. Most recently, moral hazard and adverse selection contributed to the 1980s U.S. Savings and Loan (S&L) crisis and 2007–2009 global financial crisis.
Governments that offer deposit insurance can offset a portion of the loss of market discipline through prudential supervision and regulation of banks, i.e., regulatory discipline. Calomiris and Jaremski [3] explain that regulatory discipline is unlikely to be as effective as market discipline because regulators do not have a monetary stake in banks and are subject to political pressures that can lead to ineffective bank regulation and supervision. This latter situation leads us to the second theory of deposit insurance, the political theory. Under the political theory of deposit insurance Calomiris and Jaremski [3] argue that certain constituencies in a jurisdiction can benefit from deposit insurance because it provides a subsidy to banks and bank borrowers. Implicit in the subsidy argument is the belief that deposit insurance is underpriced. This insurance subsidy and attendant moral hazard and adverse selection problems were evident in the 1980s S&L and 2007–2009 U.S. financial crises in which a period of de-regulation and de-supervision allowed thrifts and banks to dramatically increase loan portfolio concentrations of subprime commercial and residential real estate loans. Since real estate markets are prone to boom-bust cycles, the market crashes were inevitable. In both market collapses the deposit insurer was unable to cover losses at failed S&Ls and banks. The Federal Savings and Loan Insurance Corporation (FSLIC) that insured S&Ls became insolvent in 1989 after the U.S. Congress denied FSLIC’s requests for emergency funding. The FDIC’s Deposit Insurance Fund (DIF) became negative in 2009–2010 after accounting for contingent loss reserves for anticipated bank failures. The financial support programs the U.S. Treasury and Federal Reserve System offered to banks during the 2007–2009 financial crisis included capital injections under the Temporary Asset Relief Program (TARP) that helped many banks avoid insolvency, allowing the FDIC to reverse the loss reserve and restore its capital. The 2007–2009 financial crisis’ strain on the FDIC’s liquidity was severe, forcing the FDIC to use shared loss agreements to resolve bank failures. Shared loss agreements allow failed-bank asset acquirers to keep problem assets and work out credit problems over time with borrowers, sharing losses on acquired assets with the FDIC. Had the FDIC needed to place all failed-bank assets in receiverships and liquidate those assets over time there would have been insufficient liquid funds to pay insured depositors.
Calomiris and Jaremski [3] conclude that the political theory of deposit insurance explains the spread of deposit insurance internationally. If that conclusion is correct what we are left with is a trade-off between competing interests that should be considered when designing a deposit insurance scheme—i.e., design a deposit insurance system that can benefit small savers without being exploited by individuals and groups that can benefit from adverse selection. There is also a need to be sure that individuals cannot exploit the benefits of deposit insurance by structuring accounts in order to take advantage of deposit insurance coverage. For example, if a jurisdiction were to treat joint accounts as separately insured from individual accounts without aggregating individual interests in each joint account there would in effect be no coverage limit for an individual account holder who opened multiple joint accounts.
3. SETTING UP A DEPOSIT INSURANCE AGENCY
In establishing deposit insurance within a jurisdiction there are many issues to consider. One of the primary benefits of having deposit insurance is that the cost of protecting depositors with relatively small amounts of deposits (“small depositors”) should a bank fail is borne by the member institutions rather than the public through the collection of premiums from insured entities and the establishment of a deposit insurance fund. Thus, one of the first steps a jurisdiction could take in deciding to adopt deposit insurance is to establish a deposit insurance fund and begin collecting premiums from whatever financial institutions will become part of the system (for example banks, credit unions or other credit cooperatives). This fund will then begin to grow even as the final contours of a rules- based system are debated and adopted. This fund can be established within the Central Bank with a small staff dedicated to managing the collection of premiums and investments of the collected funds or in an independent organization established for such purpose. In some jurisdictions the deposit insurance fund may remain part of the Central Bank or another entity as an independent unit particularly if the number of financial institutions contributing to the fund is small and the availability of qualified personnel to set up and run a stand-alone agency is limited.
It could be that establishing an explicit, rules-based, limited coverage deposit insurance system will at first create a need for public assurances about the health of the banking system if depositors had been operating under a belief that their deposits in banks were covered by an implicit guarantee. In such situations the government steps in to cover deposits when a bank fails, thereby covering either all or at least some deposits, usually of small depositors. Moving from such implicit guarantees to an explicit system therefore requires a substantial public education effort about how such an explicit system would work. Adoption of explicit deposit insurance should be done at a time of stability in a country’s banking system so as not to put immediate stress on a new deposit insurer and potentially create a lack of confidence that such a new institution could perform effectively in a crisis.
3.1 PRIVATE VERSUS PUBLIC SYSTEMS
Public deposit insurance systems are the most common and, in many ways, can be considered to be a good practice. However, private deposit insurance systems do exist in a number of countries and the debate on the issue of whether such systems are preferable to public ones continues. However, one important challenge for private systems is the necessary constraint on the sharing of information on the condition of member institutions with that institution’s competitors and the rules surrounding bank secrecy. It may also be difficult to provide the necessary level of back-up funding to a purely private system whereas a public deposit insurer should have access to sources of public funds both for liquidity purposes and as a backstop if needed for paying insured depositors at the time of a bank failure. In such cases there could be pressure on the government to provide funding to avoid the potential contagion effects from an inability to pay depositors.
3.2 FUNDING ISSUES (SEED FUNDING, EX-ANTE FUNDING, BACK-UP FUNDING)
Funding of a deposit insurer is needed not only as it is set up but also on an ongoing basis as described above. It may be that seed money for a deposit insurer can be provided from some sort of public funding or by assessing a fee for institutions to join the deposit insurance system followed by the regular assessment of premiums on a periodic basis. Funding is increasingly done on an ex-ante basis for deposit insurers, thereby providing for the payment of premiums into a fund that accrues and is thus available in advance for use at the time of a bank failure. There are some deposit insurers use ex-post funding, thereby collecting the funds used to make a depositor payout once the payout is completed. There can also be a combination of both ex-ante and ex-post funding where a depleted deposit insurance fund is replenished through an assessment on the industry after a payout. Regardless of the type of funding there is a need for a certain source of backup funding for the deposit insurer so that the public can be confident that insured deposits will be able to be reimbursed promptly in the case of a bank failure. This is specifically addressed in IADI Core Principle 9, Sources And Uses Of Funds.
3.3 DETERMINING WHICH DEPOSITS WILL BE COVERED BY DEPOSIT INSURANCE AND HOW
An analysis of the deposit structure within a jurisdiction is essential to determining how best to set up a deposit insurance system. Deposit insurance is a tool to protect most but not all depositors in a banking system and should be designed to accomplish that goal by excluding from coverage large deposits. Exclusions from coverage can include certain categories of deposits (such as inter-bank deposits) and types of deposits (e.g., those held by insiders at an institution) and those deposits exceeding the coverage limit (e.g., the deposits held by large corporates will in most cases exceed the deposit insurance limits in place). It may be that in some jurisdictions only deposits held by individuals are covered which could have an impact on small businesses within that jurisdiction in the case of a bank failure. Core Principle 8, Coverage, addresses the issues of the level and scope of deposit insurance, requiring clear definitions of both by the deposit insurer. An increasingly important issue for deposit insurers is how to treat new developments in financial technology that are blurring the once- distinct lines between deposits and payment systems, such as e-money. Greater deposit insurance coverage of these newer methods of storing money may in some circumstances contribute to greater financial inclusion. As methods of value storage and payment accessibility are evolving deposit insurers will need to assess whether and if so how to cover these new financial instruments and how to plan for and pay out holders of such instruments if needed in the event of a bank failure.
3.4 DRAFTING A DEPOSIT INSURANCE LAW (OUTLINE OF A MODEL LAW PROVIDED)
The IADI Core Principles, as well as the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions, should be reflected in the legal framework governing the deposit insurance system. The law should cover the objectives of the deposit insurance scheme, the establishment of the insurer as a stand-alone agency or as part of an appropriate existing government agency, a specification of the mandate and powers of the deposit insurer, its governance arrangements, its funding structure including its ability to borrow in support of its mandate, and all other aspects of the deposit insurer’s operation as a member of the jurisdiction’s financial safety net. The Toolkit contains a Model Deposit Insurance Act (Appendix 13.9) to aid deposit insurers in crafting an appropriate governing law.
It is important to note that we have not distinguished between common and civil law jurisdictions in this paper although that distinction is important in structuring the laws governing a deposit insurer’s operations. In civil law jurisdictions the laws are almost entirely codified, requiring more detailed legal frameworks to be in place. Common law jurisdictions on the other hand depend to a substantial extent on published judicial opinions interpreting the legislative language in place. The model law we have attached can act as a guide for qualified practitioners within a jurisdiction to refer to when developing a law that fits within whichever legal structure is in effect in their jurisdiction.
The deposit insurance law must align with the laws governing bank resolution and supervision generally and should not be inconsistent with other laws governing the financial system. There should be a specific reference to the priority of claims that will govern the failure of a financial institution which may differ in important respects from the priority of claims that govern a corporate bankruptcy. If there is any distinction to be drawn between how claims will be paid in different types of financial institutions (for example, differing coverage levels for deposits held in smaller institutions such as credit cooperatives from larger institutions such as banks) the reason for such distinctions should be clear and should not unduly complicate the payout process for the deposit insurer or interfere with its ability to recoup its payments from available repayment sources.
4. STRATEGIC ROLE OF THE DEPOSIT INSURER
A deposit insurer is an important part of the financial safety net in any jurisdiction and as such a full partner with other safety net players in terms of information sharing, crisis preparedness and crisis management for the sector. This is true regardless of the deposit insurer’s mandate as understanding risks to the financial sector which could result in the need for the deposit insurer to mobilize its funds is essential to prudent management of the insurance fund and readiness in case of a need for an insured deposit payout.
4.1 DETERMINING THE PUBLIC POLICY OBJECTIVES (CORE PRINCIPLE 1)
A deposit insurer should have its contribution to the stability of a country’s financial system as one of its public policy objectives. This is because the existence of deposit insurance should lessen the possibility that depositors who perceive that a financial institution is troubled will “run” from that institution by withdrawing their deposits, potentially exacerbating an institution’s problems or even contributing to a perception that all financial institutions are unsound and thus creating the risk that depositors at even healthy institutions begin to withdraw their funds. The existence of deposit insurance may also increase trust in the banking system and therefore encourage more people to open bank accounts, thereby decreasing the unbanked population in a jurisdiction.
The fundamental public policy objective for a deposit insurer should be the protection of depositors, but focused on smaller retail and non-retail depositors (small and medium enterprises (SMEs). Large corporate depositors (including banks holding inter-bank deposits) are better positioned to monitor the condition of the financial institution with which they conduct business and thus theoretically can avoid the possible losses they could incur from a failure of such an institution. Covering such large depositors may create the possibility of increasing the moral hazard that can be associated with deposit insurance although the deposit insurance limit will most likely represent an insignificant portion of a large company’s bank deposits.
Other public policy objectives may also focus on failure resolution of financial institutions. The introduction of deposit insurance can shift the cost of such failures to a privately funded deposit insurance system from what in many countries in the past might have been the government. A formal deposit insurance system can also result in a more orderly and efficient resolution process, thereby advancing the public good of speedier and more certain depositor reimbursement.
4.2 DETERMINING THE MANDATE (CP 2)
IADI defines the term “mandate” as the “set of official instructions describing the deposit insurer’s roles and responsibilities. There is no single mandate or set of mandates suitable for all deposit insurers. When assigning a mandate to a deposit insurer, jurisdiction-specific circumstances must be taken into account. Mandates can range from narrow “paybox” systems to those with extensive responsibilities, such as preventive action and loss or risk minimisation/management, with a variety of combinations in between. These can be broadly classified into four categories: Paybox, Paybox plus, Loss Minimiser and Risk Minimiser as defined by IADI.
There is no preferred mandate for a deposit insurer and the choice of a mandate should be informed by individual country circumstances, policy considerations, resource issues and experience within a jurisdiction with bank failures. However, it has become increasingly clear that a solely paybox mandate where the deposit insurer is empowered to pay insured depositors only if a financial institution’s license is withdrawn and the financial institution is closed may not serve the needs of a financial sector where a transfer of insured deposits to a healthy institution when an institution becomes non- viable is not only possible but preferred to avoid disruption to established banking relationships. In order for the deposit insurer to participate in such a transfer by supplying funds in support of the resolution it is necessary that it has the more flexible paybox-plus mandate.
There are jurisdictions where the deposit insurer has the broader mandate of a loss minimiser or a risk minimiser but these jurisdictions often have a large number of financial institutions or financial institutions that, due to their complexity, might require highly developed resolution regimes. Many of these jurisdictions also have long established deposit insurance systems that have gained significant experience in serving as either risk or loss minimisers. It can be challenging to set up or expand a deposit insurer’s mandate beyond that of a paybox plus and, in a country where bank resolution is not needed on more than a periodic basis, it may not be the most efficient use of either human or financial resources. For example, where a bank resolution may occur only once in a decade it may not be efficient to have a deposit insurance agency whose mandate includes acting as a resolution authority if such a mandate requires human and financial resources that are not utilized fully in other activities in the agency.
5. ORGANIZATIONAL ISSUES FOR DEPOSIT INSURERS
There are certain functions that must be performed by any deposit insurer no matter what mandate it has. Such functions include reimbursing insured depositors of failed banks, management of bank resolution issues, collection of insurance premiums, the investment of such funds, the gathering and management of insured deposit data, the outreach to member institutions and the public about the operation of the insurance system, interactions with other members of the financial safety net and external relations with the press and others such as international organizations on the operations of the deposit insurance system. An effective deposit insurer also must have strong internal controls and accountability systems in place. Depending on the mandate or other responsibilities given to the deposit insurer it may also be necessary that there be personnel devoted to other tasks such as member institution supervision or receivership management. Appendix 13.10 presents an example of an organizational chart reflecting these various functions.
5.1 DETERMINING THE APPROPRIATE GOVERNANCE STRUCTURE (CP 3)
Core Principle 3 sets forth the rules for governance of deposit insurers. It requires that the deposit insurer “should be operationally independent, well-governed, transparent, accountable, and insulated from external interference.” The Board and management of the deposit insurer are responsible for the prudent management of the agency’s funds which, as noted below, should be part of a transparent process with appropriate disclosures to stakeholders. This standard envisions a deposit insurer that has the ability to execute its functions free from any political or other undue influence that would hinder it in accomplishing its mission. As discussed in section 2, the moral hazard problem for deposit insurance can arise in both banks and the deposit insurer.
Most deposit insurers are governed by a Board of Directors that appoints a Chief Executive Officer or management team that manages the day-to-day responsibilities of the insurer. This structure allows for the separation of board and management to allow for more independent oversight of the deposit insurer’s overall operation. An appropriate governance structure should advance the deposit insurer’s ability to manage its resources to grow its fund and limit its administrative expenses by avoiding excessive operational costs (e.g., by paying excessive board fees). There should be an odd number of positions on the Board of Directors for the deposit insurer to avoid the possibility of a tie vote when decisions need to be taken which, for most jurisdictions, would result in a Board of Directors made up of three or five members. Active bankers should also not be on the Board to allow for the sharing of information without concern of one financial institution learning of information about a competitor that might present an actual or perceived conflict of interest. It is important, however, to have private sector involvement on the board to enhance perceived independence and minimize regulatory capture. Board members should meet clear qualification standards, be covered by fit and proper rules and have no conflicts of interest that would present any issues in their board service.
Core Principle 3 makes clear that although the deposit insurer should be subject to oversight by a higher authority in accordance with general good governance practices it should be operationally independent and not be under the control of another agency or interested entity. There could be established performance metrics in place for the deposit insurer for example and such metrics could be subject to monitoring by the higher authority along with reporting requirements such as the requirement that the deposit insurer prepare an annual report. There must also be strict conflict of interest rules in place to avoid the possibility or even the perception that members of the Board could profit from their access to confidential information.
5.2 DEVELOPING A GOOD ORGANIZATIONAL STRUCTURE
After consideration of the appropriate governing board structure for the deposit insurer (i.e., three or five board members, non-government non-ex-officio chair of the board, non-active banker members, ex-officio members and other qualified members such as academics or accountants) as discussed above the next task should be to set up an appropriate organizational structure to address all needed functions. No matter its mandate every deposit insurer will need a properly designed and staffed internal audit function, legal, research, IT and administrative capabilities to properly manage
its operations. In some smaller jurisdictions the deposit insurer may be able to make use of certain functions within the central bank or supervisory agency to have access to needed services like IT without having to expend its own resources to develop independent systems. All necessary safeguards would of course have to be in place to ensure the integrity of the systems devoted to the deposit insurer’s functions. For some deposit insurers there might be a need for a separate function to manage liquidation or receivership operations. A draft of an organizational chart is attached as Appendix 13.10 as a starting point for consideration of the needs of any given deposit insurance organization.
IADI Core Principle 11 addresses the need for those working for the deposit insurer (and its former employees) to have legal protection so that actions taken in the course of the good faith performance of their duties cannot result in personal liability arising from actions, claims, lawsuits or other proceedings for their decisions, actions or omissions. Such protections are essential in order to protect employees of the deposit insurer from the potential chilling effect of the fear of being sued by a disgruntled depositor. The protection should also extend to those working for or engaged by the deposit insurer, such as lawyers or accountants, (with of course adequate oversight) because many functions performed by a deposit insurer in making insured depositors whole are carried out by contractors hired for the specific tasks associated with the closing of a financial institution. The Model Deposit Insurance Act (Appendix 13.9) contains language reflecting the need for legal protection to extend beyond current employees of the deposit insurer in Articles 96 and 97. The legal protection provided for the deposit insurer should also be available to those working as supervisors and resolution personnel in the financial system to avoid the possibility that a lack of such protection will prevent the relevant authorities from taking the necessary actions to address shortcomings in a financial institution’s operations that may of necessity lead to that institution’s exit from the financial system in accordance with good international practice.
5.4 ADOPTING A BUSINESS CONTINUITY PLAN (CP 6)
IADI Core Principle 6 addresses the role of the deposit insurer in contingency planning and crisis management and is discussed in section 6.1. However, as part of such preparedness by the deposit insurer itself it is essential that a Business Continuity Plan (BCP) be developed and implemented as needed. (See Appendix 13.2 for Outline for a BCP). Business continuity planning is the process involved in creating a system of prevention and recovery from potential threats to an institution and is designed to ensure that personnel and assets are protected and are able to function quickly in the event of a disaster. The process of developing a BCP involves defining any and all risks that can affect operations as part of an organization’s risk management strategy. Risks may include pandemics, war, natural disasters and, of increasing importance in protecting a deposit insurer’s operations, cyber-attacks. Some of these risks may require the deposit insurer to be able to work remotely and to access information through off-site facilities and equipment.
5.5 MANAGING OPERATIONAL EXPENSES
It is essential that a deposit insurer manage its resources efficiently and effectively in order to build and maintain its insurance fund. As a deposit insurer begins operations it will have significant expenses such as those associated with developing the necessary computer systems and training staff to be prepared for an insurance payout. However, there should be oversight by the management of the institution at the highest levels to ensure that administrative expenses remain reasonable and that such expenses are fully disclosed to stakeholders. See, e.g., Appendix 13.9, Model Deposit Insurance Act Article 6.
It may be appropriate for management to adopt in a transparent manner a benchmark for such expenses as a percentage of its operating budget (for example administrative expenses will normally not exceed a given percentage of investment income of the fund). Management should also routinely review processes for payout to insured depositors to be sure that all modern payment systems are incorporated in their planning for a payout, including the budgeting for such payouts.
6. CRISIS MANAGEMENT AND RESOLUTION ISSUES AFFECTING THE DEPOSIT INSURER
This section addresses the issues affecting a deposit insurer associated with crisis management and resolution. It is designed to offer general guidance on such issues as well as to provide some examples of documents that should be part of a deposit insurer’s toolkit to guide its work.
6.1 DEVELOPING A CRISIS MANAGEMENT PLAYBOOK (CP 6)
Core Principle 6 addresses the role of the deposit insurer in contingency planning and crisis management:
A deposit insurer should develop procedures and documents to guide its ongoing work processes such as collection of data, assessment of premiums, dissemination of information about the deposit insurance scheme and other routine matters. As discussed above, it should also engage in contingency planning on an ongoing basis and will have in place a BCP that will guide it in a situation where business processes are interrupted by events including natural disasters or manmade events such as power outages. However, during a financial crisis there may need to be additional processes in place as well as prepared guidance on how the deposit insurer will respond to the crisis as part of the financial safety net both for the public and for use by all members of the crisis response team. Such processes should be guided by a crisis management playbook that sets forth the responsibilities of the deposit insurer in a financial crisis and provide guidance as to how those responsibilities will be handled, as well as Memoranda of Understanding signed by key players in the financial safety net. The deposit insurer should have comprehensive plans in place for executing a payout including all the operational pre-positioning for such execution such as access to depositor files and secure portals between itself and its member institutions for data transmission on a real time basis. There should also be a plan for how the deposit insurer will execute its role (if any) in completing a resolution action such as a purchase and assumption transaction.
Some examples of what should be addressed in a playbook are how to retain needed temporary help, how to develop needed communication tools such as relevant press releases and Frequently Asked Questions (FAQs), what type of governance structure for crisis management will be in place (for example will there be a Crisis Management Committee established within the organization and if so how will it be staffed), how will delegations of authority work in a crisis (standard delegations may need to be modified to deal with the greater demands on the organization during a crisis), how will public procurement issues affect the deposit insurer’s preparations, identification of additional expenses that may be incurred and how will such expenses be managed (will the budget process be modified in any way to address additional spending needs in a crisis such as the payment of greater overtime to staff) and how will coordination with other members of the financial safety net or the government as a whole be managed. See Outline of a Crisis Management Plan, Appendix 13.7. The plan can be tested by the use of crisis simulation exercises conducted in coordination with other members of the safety net.
6.2 REPRESENTATION OF DEPOSIT INSURER ON CRISIS MANAGEMENT COMMITTEES (CP 6)
Addressing a financial sector crisis is not the job of only one member of the financial safety net or the government. Management of such a crisis requires detailed analysis, often in a short period of time, of substantial, often complex data about the interactions of various parts of a country’s financial system. For that reason, it is good practice to have in place a forum for relevant regulators and government representatives such as the Minister of Finance for the exchange of ideas and information on a regular basis as well as the sharing of information during a crisis situation. Establishing an interagency dialogue on financial stability in normal times can significantly contribute to better interagency coordination in crisis situations. The work program of such a committee can focus on microprudential issues such as regulation and supervision of financial groups, alignment of regulatory frameworks, the routine exchange of relevant information and capacity building, macroprudential issues including the timely detection and mitigation of risks for the entire financial system and systemic crisis management (once such a crisis is declared).
Participants in such a crisis committee should not only include the Ministry of Finance but also the Central Bank, the Supervisory Authority (if separate from or even as a separate division within the Central Bank), the deposit insurer and any regulators for the securities and pensions sectors if significant in the financial sector. Other parties can be asked to participate in Committee meetings to bring additional perspectives to the dialogue or to provide additional expertise.
The committee can be established by legislation or regulation or even through the signing of a Memorandum of Understanding. [An example of a Financial Crisis Committee Operational Memorandum can be found in Appendix 14.14].
6.3 ISSUES INVOLVED IN DETERMINING THE OPTIMAL HIERARCHY OF CLAIMS IN LIQUIDATION
A company may go into insolvency proceedings and its assets will be marshalled by a bankruptcy judge or practitioner to pay the creditors of the insolvent firm to the extent assets are available. As the assets are liquidated, creditors of the firm are paid in priority order in accordance with the law governing insolvency proceedings. Administrative claims, claims for wages, tax claims, secured claims, claims of general creditors and finally shareholders will be paid either in full if possible or only to the extent assets are not exhausted by the payment of higher priority claims.
The hierarchy of claims in liquidation for financial institutions is usually different than the general priority followed in bankruptcy proceedings because of the need to address the priority of depositors’ claims, both insured and uninsured. The ranking of the deposit insurer’s claims and how such claims are defined has a direct impact on the required funding for the deposit insurer and also may impact the behavior of senior creditors as a financial institution is perceived to be experiencing financial difficulties. There is also the possibility that a financial institution has outstanding advances from the Central Bank which may be given the highest priority for recovery on the institution’s assets to avoid putting the balance sheet of the Central Bank at risk, thereby lessening the funds available for the reimbursement of a deposit insurer’s payments.
The priority of claims is often contained in a country’s banking law or, if there is a separate law governing bank resolution it can often be found there. Less often such a priority of claims can be set forth in the deposit insurance law. Wherever it is found it should clearly set forth which claims will take priority on the proceeds of a liquidation action, which must then be followed in completing resolution actions so as not to create preferences for creditors.
The priority scheme in place has a real impact on what could happen as a financial institution approaches insolvency. Sophisticated market players may have made secured loans to such an institution and may call such loans or begin to realize upon their collateral which can have a serious impact on the already-stressed institution’s balance sheet if no priority for secured claims is provided in liquidation. As stated above, the Central Bank may also have extended secured loans to the troubled institution.
There should also be a provision for the payment of liquidation expenses as an administrative claim. Without a priority of payment of liquidation expenses, it will be difficult if not impossible to have a party other than the government act as liquidator. As discussed above, careful consideration should be given to whether secured creditors should be able to satisfy their claims either outside of the priority scheme or as a first priority, to the extent of their security.
The issue of the appropriate priority for the claims of insured and uninsured depositors involves important policy issues and should be the subject of a robust discussion and a weighing of the pros and cons of the different choices that can be made in this regard. There are various types of depositor preference that can be adopted as part of the bank resolution framework. Full depositor preference gives a priority over other creditors for all depositors, both insured and uninsured. With no depositor preference, depositors (and the deposit insurer to the extent of its subrogation) share in the recoveries from the liquidation with other creditors (usually general creditors) pro rata. Insured depositor preference allows the deposit insurer to recover to the extent of its subrogation before uninsured depositors, thereby making it more likely that it will largely or fully recover its cost for providing deposit insurance.42
The priority scheme also has a significant effect on whether the deposit insurer’s funds will be available to be used to facilitate a resolution (see Core Principle 9, Sources and Uses of Funds). To the extent there is no priority for secured claims it may make the need for a contribution to a resolution by the deposit insurer less likely, thereby shifting at least part of the cost of resolution to any secured creditors left at the time of a bank’s failure. This is so because the deposit insurer would in most liquidations incur no or a small cost for its payment of insured deposits if it has a high priority in the ranking of claims and more money would be available in the liquidation because secured creditors would not first recover from the estate to the extent of their security. If the measure of the contribution the deposit insurer makes to a resolution is what its cost would be to complete a payout (see discussion under Funding of Resolution) then a high priority for recovery of the deposit insurer’s payment of insured claims corresponds to a lower contribution amount for resolution.
6.4 HIERARCHY OF CLAIMS AND FAILURE RESOLUTION COSTS
In the absence of a specific law governing bank resolution, upon the failure of an insured bank the disposition of the failed-bank’s assets and liabilities is determined by bankruptcy law in the jurisdiction and any bilateral arrangements made for cross-border claims. Bankruptcy law, as applied to personal and corporate bankruptcy, can result in a lengthy period before claims are resolved.
This has proven to be ill suited to the resolution of bank failures since a drawn-out failure-resolution process can pose significant financial hardship on commercial and consumer depositors who depend on deposit accounts for day-to-day transactions. Nascent deposit insurance systems may have to rely on existing bankruptcy law; however, separate bankruptcy laws for banks that allows for more immediate payment to insured depositors is preferred.
From the deposit insurer’s perspective, there are two important considerations regarding the priority of claims in a failed-bank receivership. The first is the priority of insured depositor claims in the receivership since this is the deposit insurer’s subrogated claim on the receivership. The higher the priority of insured depositor claims in receiverships, the greater the insurer’s share of recoveries from failed-bank asset liquidations and failed-bank franchise sales. In many jurisdictions, recoveries from failed-bank receiverships are extremely small, due to a combination of delays in bank insolvency determination, poorly designed bankruptcy laws, poor enforcement of contractual obligations by the court system and a lack of legal protections for government officials responsible for closing insolvent banks. The second consideration is how receivership expenses are defined and prioritized as claims against the receivership. Typically, receivership expenses, both internal expenses and external (contractor fees), receive priority over all other receivership claimants. This high priority makes sense from an operational standpoint since receivership expenses would eventually exhaust insurer capital should these expenses be effectively non-reimbursable due to low priority in receivership claims.
The deposit insurer’s claim on receivership recoveries is determined by the proportion of insured deposits-to-total deposits under depositor preference law or proportion of insured deposits-to-total liabilities without depositor preference. Clearly, as changes to the treatment of insured deposits in the receivership claims process are made there is a substantial impact on the likelihood that one will recover enough proceeds from the receivership to cover insured depositor claims, i.e., the insurer will incur a small or no loss.
The recoupment of deposit insurer funds after liquidation may also depend on creating a legal environment that allows for an expeditious recovery process. There are ways to simplify the liquidation process by allowing for determinations of no-asset receiverships or permitting notice of the abandonment of claims that might be too costly or time-consuming to pursue. These are areas that may require changes in the law governing bank liquidation procedures.
6.5 FUNDING OF FAILURE RESOLUTION (CP 9)
Core Principle 9 addresses a number of issues relating to funding for the deposit insurer 46 but for purposes of the discussion on the appropriate measure of a deposit insurer’s contribution to resolution the relevant Essential Criteria is number 8:
Implementation of these rules will require close cooperation between the bank regulator, the deposit insurer and the resolution authority in determining not only the level of the contribution of the deposit insurer to a resolution but also whether that contribution can be made under the legal framework in place. The board of the deposit insurer must authorize the use of its funds and the amount to be contributed. This will require not only the sharing of relevant information about the losses at the targeted financial institution but also the likely recoveries that would have been realized if the institution had been liquidated. It will also require cooperation between the deposit insurer and the resolution authority if there is a requirement that resolution actions must meet a least cost test. All of these matters can be governed by a cooperation agreement between the deposit insurer and the relevant authorities (i.e., supervisor and resolution authority) (see attached cooperation agreements, Appendices 14.5 and 14.6).
Core Principle 16 sets forth the requirement that the law address the need for the deposit insurer to recover the funds it advances for the payment of insured deposits:
Importantly this Core Principle does not specifically address how the hierarchy of claims should be designed (discussed above) nor does it make clear that the deposit insurer’s costs should also be recovered either as an administrative expense or as part of the subrogated claim for its payment of insured deposits. The choice of how such costs will be recovered will of course have an impact on the deposit insurer’s funding and also how much it can contribute to resolution.
Every public and private sector organization has a structure comprised of rules, roles and responsibilities that drive the organization’s activities. An organization’s structure can be very simple, e.g., an organizational hierarchy that determines who does what and when. Organizational design is used to make choices about the workflow of an organization that are not driven by organizational structure. A deposit insurer’s structure is determined by the laws and regulations that establish the deposit insurer, determine its powers and responsibilities, as well as its financing—sources and uses of funds. Depending on the rigidity of the structure, deposit insurers are able to make design choices.
We begin this discussion of deposit insurance premiums by comparing insurance premium setting for commercial and consumer insurance (e.g., property, casualty and life insurance) with deposit insurance premium setting practices. We believe a review of the similarities (dissimilarities) in premium setting practices for commercial and consumer insurers compared to deposit insurers, and the reasons for those similarities (dissimilarities), can assist in understanding deposit insurers’ unique situation.
COMMERCIAL AND CONSUMER INSURANCE PREMIUMS
Business and personal insurance premiums are charged over the life of the insurance contract and are collected prior to insurance claims. These Insurers seek to collect sufficient premiums to cover expected losses due to claims, as well as operating costs, and return a profit. Expected insurance losses (L) over the life of the contract (T) are typically modelled as the product of the expected average loss per claim (severity, or lifetime losses divided by expected number of claims, L/N) and expected number of claims (N) over the life of the contract (frequency, N/T), as shown in equation 1:
Commercial and consumer insurers assume that claim frequency and severity follow known probability distributions and are distributed independently of one another. The claim frequency is typically assumed to follow a Poisson distribution where the vast majority of insured entities (businesses or individuals) do not file claims over a given period (exposure) and the frequency distribution of the number of claims per insured entity is highly skewed toward the left. To predict claim frequency insurers have used generalized linear models (GLM) with a Poisson link function. The frequency distribution of claim severities is also skewed to the left and is often assumed to follow a gamma distribution. The gamma distribution results from processes where the interval between events is meaningful and events (e.g., claims) follow a Poisson process. To predict claim severity insurers have used generalized linear models (GLM) with a gamma link function. In recent years, insurers have used machine learning methods, such as decision tree methods, to model claim frequency and severity. The dependent variables in these models are measures of claim frequency and severity and the explanatory variables are measures correlated with claim frequency and severity. Explanatory variables include attributes of the insurer entity and the property that is insured.
DEPOSIT INSURANCE PREMIUMS
Deposit insurers incur losses when a bank fails, i.e., becomes insolvent. The extent of deposit insurer losses depends on several factors. First, failed-bank receiverships typically charge all expenses associated with managing the receivership and liquidating assets to the receivership. As a consequence, only the net proceeds of the receivership (gross recoveries minus expenses) are available to reimburse receivership claimants. Insured deposit reimbursement is typically not considered a receivership expense. Second, the priority that insured depositors have in the claims process affects how much of bank-failure resolution costs the insurer might recover from the receivership as the insurer’s subrogated claim on the receivership is based on insured deposits. Secured liabilities may have first claim on the net receivership recoveries and should the jurisdiction have enacted depositor preference laws all depositors have second claim on net receivership recoveries. Under depositor preference, the insurer’s claim on net recoveries, after secured claims, is determined by the ratio of insured deposits-to-total deposits, as shown in equations 2, 3 and 4.
The deposit insurer’s share of net recoveries can vary substantially across banks depending on the level of insured deposits. If depositor preference laws have not been enacted, the deposit insurer’s share of net recoveries is determined by the ratio of insured deposits-to-total liabilities, net of secured liabilities if given preference, and that share is typically much less than the share under depositor preference.
As is the case with commercial and consumer insurance, deposit insurers typically model losses by separately considering three components of loss—probability of bank failure, loss rate on exposure given failure and insurer exposure at time of failure (insured deposits)—using a credit risk model approach based on Merton [20]. Merton models a firm financed with a single bond and equity. Merton argues bond holders have a call option on the firm’s assets that can be exercised when the market value of its assets is less than that of liabilities (the bond), implying the firm fails. In the Merton model bank default is synonymous with bank bankruptcy, hence we use the terms default and failure interchangeably in this document. Under the credit risk model approach, the expected loss to the deposit insurer from the default of bank k at time t is the product of the bank’s probability of default (PD), insurer loss given default (LGD) and insurer exposure at time of default (EAD), as shown for failed bank k in equation 5:
At a point in time, the deposit insurer may have a reasonable estimate of EAD based on reported bank liabilities but will need to find ways to estimate PD and LGD for an expected bank failure. Historical recovery data from receiverships can be used to find average net recovery rates for different asset classes and applied to a bank’s balance sheet to determine expected net recoveries. The insurer’s expected share of net recoveries and losses after insured depositor payments can then be computed. Deposit insurers have also used regression models to estimate LGD by relating observed loss rates for failed banks to bank condition and performance indicators, as well as macroeconomic indexes. The probability of bank failure (PD) can be modelled using binomial logit models that relate the incidence of bank failure to bank internal factors and external macroeconomic factors known to be correlated with failure.
As shown in equation 6 the log odds ratio of the probability of failing-to-not failing is regressed against a set of explanatory variables, Xj,k, representing bank j’s characteristics, with estimated coefficients, βk, and intercept, α. Failure models may also include indexes of local and national macroeconomic conditions and other types of indexed (e.g., dummy) explanatory variables, Gj,k, with estimated coefficients, λk. We leave out time subscripts in equation 6 for simplicity, however, all explanatory variables would be measured on or prior to some date prior to bank failure. In failure models presented in this guide all explanatory variables are measured 12 months prior to the time of failure.
For ease of discussion, let Zj, represent the linear combination of bank j’s explanatory variables and intercept term, as shown in equation 7:
To estimate the probability that bank j fails within 12 months, one takes the product of estimated coefficients and bank j’s values for the explanatory variables and inputs the sum of these products plus intercept term into the inverse logit function (equation 8), and assumes the regression error term, ε, is zero.
As equations 7 and 8 indicate, the impact of a change in an explanatory variable of a bank’s predicted probability of failure depends on the value of the variable and all other explanatory variables. This property of logit regression is very different from the properties of linear regression when the impact of an explanatory variable on the dependent variable is constant across variable values and independent of other explanatory variable values.
We chose logistic regression as our estimation technique since it is particularly well suited to bank failure prediction. Logistic regression is useful when the events being modeled (failure) are relatively rare in the estimation sample. Further, logistic regression assumes the data are log-normally distributed rather than normally distributed; log-normality is by far an easier criteria to satisfy than normality. Finally, a majority of industry and academic models of default (failure) use logistic regression and this allows researchers to compare the performance of their models to previous research.
As a robustness test of the logistic regression results we also estimated the preferred models using another econometric technique—probit regression. The results of probit regression estimates of the failure models are not materially different than those we obtained using logistic regression. As is the case with commercial and consumer insurance, deposit insurers can also apply machine learning models for estimation of PD and LGD.
In terms of premium setting, commercial, consumer and deposit insurers base premium rates on expected losses and operating expenses. Deposit insurers, however, do not have expected profit margins for compensating the risks to the insurer. Aside from the relative merits of charging for risks borne, it would be difficult for a deposit insurer to determine an appropriate profit margin since most deposit insurers have a monopoly on providing deposit insurance and lack a reasonable benchmark profit rate. Further, as public sector institutions, deposit insurers have less flexibility in terms of premium setting than do private sector insurers. Deposit insurers’ ability to determine premium rates is limited by the laws establishing the insurer. Historically, deposit insurers were limited to using a single insurance premium rate for all banks—flat rate—where the rate is applied to a base that is typically insured deposits. Many deposit insurers currently use flat-rate insurance premiums. That rate can be adjusted upward (downward) over time depending on the insurer’s funding needs, however, the process of changing the industry-wide premium rate can be slow and require revision of laws for premium setting. This type of deposit insurance pricing process opens premium setting to political considerations where interest groups can be successful in ensuring deposit insurance is underpriced, shifting risk onto taxpayers.
A second approach to premium setting is the use of risk-related premiums where premium rates vary based on factors found to be related to the likelihood of bank failure and might also include factors related to the cost of resolving failures. In statistical terms risk-related premiums are based on the probability a bank defaults on its obligations and deposit insurer loss given default. Risk-related premium systems can use PD and LGD estimates to place banks into cohorts where a single premium rate is applied to all banks within a cohort, however, rates can vary across cohorts. Table 1 provides a hypothetical risk-related premium matrix based on PD and LGD estimates (rounded to nearest whole percent). We should point out that the premium rates used by the matrix will adjust to take into account the deposit insurer’s funding needs, hence, the table’s importance is in providing relative changes in premium rates as bank risk varies.
TABLE 1. HYPOTHETICAL RISK-RELATED PREMIUM RATE MATRIX
Risk-related premiums can be based on statistical models of the probability of bank failure and loss given failure, allowing for a continuous rate setting model that can vary rates at the bank level.
7.2 FUNDING ISSUES (EX-ANTE FUNDING, BACK-UP FUNDING) (CP 9)
It is generally recommended that deposit insurers collect funds to resolve bank failures before the failures occur, i.e., ex ante funding, as opposed to obtaining funds after failures occur (ex post funding). Ex ante funding helps ensure the insurer in most cases can reimburse insured depositors of failed banks quickly. Commercial and consumer depositors typically cannot withstand delays in access to deposits without incurring serious economic harm. Sources of ex ante funding include the equity capital provided to the insurer at the time of its establishment (which may be public funds), and deposit insurer net income (premiums and investment revenue net of operating and failure resolution expenses).
While national deposit insurers may have the backing of the government, should the insurer lack sufficient funds to reimburse insured depositors of failed banks, that backing can be delayed and sometimes thwarted by bureaucratic, legal and political processes. For example, in the United States
the insurer of savings and loan institutions (S&Ls) that existed prior to 1989, the Federal Savings and Loan Insurance Corporation (FSLIC), was severely underfunded and could not resolve the several hundred S&Ls that had become insolvent due to a high interest rate environment. The United States Congress failed to provide sufficient funds to adequately recapitalize FSLIC, hence, insolvent S&Ls remained open for extended periods of time and incurred ongoing losses, thereby significantly increasing the cost of S&L failure resolutions.
Although a good practice is to have access to back-up funding made explicit in the law governing the deposit insurer’s obligations that is not always in place. Therefore, it is essential that deposit insurers have in place agreed access to back-up funding (see IADI Core Principle 9) and a process in place to access that funding when needed. That process can be set forth in a Memoranda of Understanding (see example in Appendix 13.8) signed by the deposit insurer, the government and the central bank, with consideration being given to the jurisdiction’s legal framework for lending to public institutions. The information required by the government to provide such funding should be set forth in the MOU to eliminate as much as possible any delay in gaining access to the funds needed for prompt payment of insured depositors. In some jurisdictions deposit insurers have access to government guarantees for the issuance of debt which can provide an alternative source for needed funding but in times of serious financial stress in a jurisdiction it may be difficult for the deposit insurer to issue such bonds thereby requiring more ready access to funding from the government.
Liquidity funding must also be available to the deposit insurer. Such funding is distinct from back-up funding in that a deposit insurer with sufficient funds to complete a payout may face constraints in accessing those funds if they are not liquid. This can happen if the deposit insurer’s funds are invested in long-term government securities or other assets that are not immediately able to be converted into cash in the existing financial market. According to IADI [16], CP 9 states as an essential criteria:
It may also be that the deposit insurer wants to avoid the signaling effect a large-scale security sale on the open market could have. For these reasons it is necessary for the deposit insurer to have a repo agreement in place with the Central Bank to allow it to convert its government securities when needed even if those securities have not yet reached maturity. Such agreements are common between central banks and market participants and should be adapted as needed for use by the deposit insurer.
In summary, back-up (contingency) funding is provided by a government department, e.g., Ministry of Finance. The contingency funding allows the insurer to resolve bank failures in the near term and to repay the government over time. Liquidity funding arrangements provide liquidity (working capital) to the insurer, allowing it to resolve bank failures associated with a banking crisis without requiring it to access the capital markets if such access would either be unavailable or would create unwanted signaling of an upcoming financial institution resolution action.
7.3 ESTABLISHING A TARGET FUND (CP 9)
The deposit insurer’s target fund ratio, i.e., optimal insurance fund-to-insured deposits ratio, can be specified in the deposit insurance law. As is the case with premiums, deposit insurers have varying degrees of flexibility and responsibility in target fund determination. For this discussion we assume that deposit insurers have a voice in target fund setting either individually or in concert with the national government and can offer suggestions for how the target fund can be determined.
Deciding the optimal funding level for a deposit insurer is very different from determining capital adequacy for private sector firms. In the private sector setting, financial theory suggests firms should select a mix of debt and equity finance that minimizes the weighted average cost of capital while maximizing the firm’s value (market value of equity). The greater a firm’s reliance on debt the greater the probability it will default on interest payments on debt since interest payments are a contractual obligation, hence interest costs rise with debt levels. While equity shareholders expect to receive periodic dividends, firms can lower and even cease dividend payments should they need to since equity dividends are a discretionary choice for firm management.
Deposit insurers may be able to use debt finance if they have access to contingency funding from the national government. However, contingency funding provided by the government is back-up funding, to be used if there is severe capital stress on the insurer. It is incorrect to think of the deposit insurer’s finance problem as deciding on an optimal mix of debt and equity that reduces the weighted average cost of capital and maximizes the market value of the insurer. Rather, the deposit insurer’s optimal funding is the appropriate level of equity capital available to absorb bank-failure resolution costs for a time period and loss level commensurate with the insurer’s risk tolerance.
SYSTEMIC EVENTS
As a practical matter, jurisdictions do not expect deposit insurers to absorb the full cost of widespread bank failures caused by systemic events. Whether planned or unplanned, it is a historical fact that government intervention has been used to offset deposit insurer losses in virtually all severe banking crises internationally. A rationale for this approach is the opportunity costs of deposit insurer capital requirements should insurers be expected to address systemic banking crises. Diverting large amounts of funds from banks to the insurer through insurance premiums will reduce bank lending. Having those funds available for private sector investment is a strong reason to limit the insurer’s risk tolerance.
NON-SYSTEMIC EVENTS
Now we are left with two related questions: what severity of loss is the insurer expected to absorb through capital, and over what time period would these losses occur? The time horizon for insurer losses is an important consideration, since deposit insurer losses, unlike commercial and consumer insurance losses, tend to be serially correlated. Downturns in commodity markets such as oil and real estate have contributed to banking crises in the United States and other countries. Energy markets, whose prices are influenced by cartels, are inherently risky. Further, recent events associated with energy market supply chain disruptions due to the COVID-19 pandemic and the war in Ukraine pose a serious risk to energy market lenders. Commercial and residential real estate development are inherently risky given the time horizon between project funding, completion, and property sale/ refinance. The result is that oil and real estate markets tend to follow “boom-bust cycles,” wherein banks increase lending to these sectors during the boom phase, providing project finance with deferred interest payments. When real estate markets experience price declines, borrowers are unable to refinance maturing loans and/or sell properties at prices that can reimburse bank lenders. The result is that bank failures tend to be serially correlated, where failure rates increase during sectoral market downturns that can last several years, and failure rates abate as markets recover.
DETERMINING DEPOSIT INSURER RISK TOLERANCE
Some have argued that the deposit insurer’s risk tolerance should be aligned with the sovereign debt rating in its jurisdiction when the “full faith and credit” guarantee of the sovereign backs the deposit insurer. Under this approach, if sovereign debt is rated, e.g., Aaa, by credit rating agencies, the default risk of the deposit insurance guarantee could be calibrated to that implied by the Aaa sovereign debt rating. As a hypothetical example, assume credit rating agencies have computed cumulative Aaa sovereign default rates for one-, two- and three-year periods between 1984 and 2010 as follows:
In our hypothetical example, an insurer wishing to maintain credit worthiness equal to that of Aaa- rated sovereign debt and be able to maintain that credit worthiness through a 1-year period could set the confidence level for solvency of the insurance fund at 97 percent. That is, set the target fund level such that the fund could absorb 97 percent of possible bank-failure resolution costs incurred over a 1-year period, calibrated to a chosen historical period.
TARGET FUND CALIBRATION EXAMPLE
As an example of target fund calibration, we use the frequency distribution of FDIC losses between 1984 and 2019, in which approximately 97% of annual losses were less than $25 billion; implying a target fund of $25 billion under the earlier hypothetical Aaa credit rating example. Figure 1 shows the target fund derivation based on a histogram of FDIC losses between 1984 and 2019; this period includes three U.S. banking crises—Southwest 1980-1989, New England 1989-1992, and the U.S. financial crisis of 2007-2009.
If the insurer wishes to be able to absorb losses by relying only on capital over longer periods, e.g., 3 years, the cumulative bank failures and insurance losses for a given credit rating group increases
compared to a one-year horizon. Again, if targeting a level of creditworthiness (sovereign credit rating) is the insurer’s goal, then the variation in confidence levels for fund solvency across different horizons is not an issue. Should the insurer feel raising insurance premium rates during a period of economic stress is counterproductive due to the adverse effect it will have on banks, a longer-term view of fund adequacy is appropriate.
ECONOMIC CONDITIONS
Another consideration for determining the target fund is the economic conditions the insurer feels it should be able to withstand, outside of systemic crises. Insurer losses will vary when estimated over periods that have different underlying economic conditions. If adequate historical data are available, domestically, or for a similar jurisdiction, the insurer can explore the use of periods that exhibit a range of economic conditions—e.g., baseline, adverse and severely adverse. This type of analysis is used in scenario modelling which we discuss in a subsequent section.
7.4 SETTING AND RE-EVALUATING INSURACNE COVERAGE LEVELS (CP 9)
To determine coverage levels jurisdictions should weigh the trade-offs between the benefits and costs of increasing insurance coverage levels. Increases in deposit insurance coverage can aid in attracting depositors to banks thereby expanding the availability of credit through financial intermediation. While deposit insurance mitigates the risk of bank runs, the moral hazard that comes with deposit insurance can de-stabilize banking markets. Jurisdictions should therefore work to ensure some degree of market discipline remains in banking markets by not offering excessively high coverage levels. Further, regulatory discipline of banks should be supported by an effective bank supervision program. Finally, the benefits of deposit insurance can only be realized if there is a bank-failure resolution process that reimburses depositor claims within a reasonable time period, i.e., immediately upon bank closure-to-several days after bank closure.
DEPOSITORS COVERAGE TARGET
Some jurisdictions evaluate nominal deposit insurance coverage levels (i.e., coverage levels measured by the local currency) in terms of the percentage of depositors whose accounts are fully insured, e.g., 90 percent of all depositors in the jurisdiction, which we denote as the “depositors coverage target”. Given a depositors coverage target, the nominal deposit coverage level is adjusted to reach that target. While this target might meet the needs of small depositors, there could be unintended consequences for this type of target. This approach to setting nominal coverage levels might result in individuals limiting deposits to be within “low” nominal coverage limits. As a consequence, reaching a depositors coverage target can be misleading. That is, achieving a depositors coverage target may be nothing more than maintaining the status quo for an underdeveloped financial system. We next discuss approaches for setting nominal deposit insurance coverage levels that consider goals of deposit insurance beyond protecting “small” depositors—i.e., supporting economic development through a healthy financial system.
MULTIFACTOR COVERAGE APPROACHES
We believe deposit insurers can benefit from considering factors other than the percentage of depositors fully insured when choosing deposit insurance coverage levels. Specifically, factors associated with the financial needs of consumers and small non-financial businesses.
Consumers’ use of financial services is correlated with their income and occupation. In developing countries consumers’ needs for financial services are often met through microfinance institutions rather than banks. In many cases, consumers do not have access to banking services due to the very small amounts of money they wish to deposit or borrow, the high cost of banking services at such institutions and their lack of documented creditworthiness. Adding to the problem of lack of access to banks is the fact that some types of microfinance deposit taking institutions are not covered by a formal deposit insurance scheme but rather rely on no or informal deposit insurance schemes set up the microfinance institution. Business’ demand for financial services is similarly dependent on the scale and scope of business operations that is reflected in revenues and expenses. As is the case for consumers, in developing countries small firms’ financial service needs are often met through microfinance institutions.
Table 2 provides an example of a list of factors one might consider when selecting deposit insurance coverage levels. We suggest, without proof, that the deposit insurance needs of the population increase for each factor as one moves from the 1st to 5th column of factor values. The level of detail one might include in this type of analysis would depend on the available information and would likely exceed the several factors and factor levels in our example. One could identify coverage factors and meaningful levels of those factors through statistical regression analysis of bank and other deposit taking institutions’ data, as well as surveys conducted by domestic and international non- governmental organizations, e.g., International Monetary Fund and World Bank Group. The range in factor values is table 2 might be estimated using statistics based on both banks and all other deposit taking institutions, as available.
TABLE 2. EXAMPLE: FACTORS INFUENCING DEPOSIT INSURANCE COVERAGE
Using the information provided in table 2 one could evaluate the degree to which sub-segments of consumer and non-financial business sectors, defined by each cell, would be insured at various coverage levels. For example, the median monthly income in India as of 2022 is estimated to be 16,000 rupee ($211 USD). Hence, a coverage level of 16,000 rupee would fully insure deposits for monthly income up to half of the 3rd income quintile. Similar analysis could be conducted by occupation and other consumer characteristics. The benefit of the multifactor approach to coverage analysis is that it shows who benefits from deposit insurance coverage and who does not. For countries with severe income inequality, the use of ranges of consumer segments is preferred to single statistical measures, such as average monthly income, since averages are misleading when data distributions are skewed. At a minimum, the multifactor coverage approach informs the insurer about which segments of the economy benefit from a specific, nominal coverage level. Further, the insurer can use the multifactor coverage approach to monitor coverage levels over time and adjust coverage, as needed. To directly address the adverse selection and moral hazard problems, however, one needs a more comprehensive solution for determining coverage, which we discuss next.
MARKET-BASED TARGETS
We propose that two problems associated with deposit insurance—adverse selection and moral hazard—can be addressed by changing deposit insurance that is provided by the public sector from a contract with banks to a contract with depositors. The current system of deposit insurance provided
by the public sector in virtually all jurisdictions is a contract with banks that removes the insurance beneficiary—depositors—from insurance market decision makers. If deposit insurance was a public good in the economic sense, i.e., a good for which any one individual’s consumption does not detract from another individual’s consumption and once provided, individuals cannot be excluded from consuming it, the decision to provide the good is a matter of public policy. The enhanced stability of banking markets that deposit insurance provides (i.e., reduced risk of bank runs) is an argument for the view of deposit insurance as a public good. There is a countervailing view, however, that deposit insurance is not a public good. This latter view points out that individuals and groups can, at times, use deposit insurance to advance their interests over those of others (Calomiris and Jaremski [3]).
An example of this latter view is the U.S. S&L crisis of the late 1980s in which many thrifts used the deposit insurance guarantee and “full-faith-and-credit” backing of the U.S. government to engage in unsafe and unsound banking practices in order to reap monetary rewards for thrift owners and managers. The next question is how to include depositors as decision makers in deposit insurance schemes?
We propose as a solution to adverse selection and moral hazard problems of deposit insurance to have deposit insurance offered to depositors who, in turn, pay premiums to the insurer. As a condition of the insurance offering, banks must agree to financial disclosure and onsite safety and soundness examinations by the insurer and/or supervisory authority. Since banks benefit from being able to offer insured deposits, banks would also be required to pay a fee (e.g., co-pay premium) to the insurer. To simplify the process of premium payments, banks could charge depositors for their share of the premium and remit the full premium (bank and consumer premium) to the insurer. Insurance premiums would be used to maintain an insurance fund held by the insurer. The insurer would be authorized to vary premium rates at the bank-level based on a bank’s safety and soundness and potential cost to the deposit insurer should it fail. Depositors would be able to increase insurance coverage, up to some maximum level, where the nominal premium would necessarily increase with coverage.
The potential benefits of the proposed deposit insurance coverage system are reductions in adverse selection and moral hazard through the disclosure of insurance premium rates that are tailored to each bank’s risk profile. Ideally, depositors would have incentives to direct their deposits to well-run banks where insurance premium rates are lower than they are for riskier banks. There has been a historical pattern of banks with risky business strategies offering high interest rates to attract depositors and under fixed, uniform deposit insurance guarantees by the sovereign, this has been a successful funding strategy. Under the proposed market-based coverage target, depositors seeking higher interest rates might face significantly higher insurance premiums should the bank’s risk level be high. Similarly, banks offering above market interest rates on deposit accounts could face higher co-pay insurance premiums should their risk level be high.
The costs of the proposed insurance scheme include the possibility that some depositors will forego insurance coverage and assume that the market discipline provided by other depositors, as well as supervisory discipline, will curtail risky bank business strategies—i.e., free riders. To address the free rider problem, a minimal mandatory level of insurance could be provided by the insurer, with coverage calibrated to low-income depositors.
Another cost of the proposed deposit insurance scheme would be the risk of depositor flight from weak banks during periods of economic stress. To mitigate such risks governments could offer support directly to banks through means such as those used in previous banking crises—facilities that support security and loan prices though central bank purchases of these assets, temporary capital injections to banks with viable franchises and insurance for bank loan portfolios.
The market-based coverage target is individually set by each depositor. In this scheme the public sector insurer offers “policies” to consumers and small non-financial businesses and these same groups decide on both the bank and coverage level for their deposits. The premium “burden” of a market-based coverage system is similar to current systems in which insurance premiums are paid by banks. Banks, in turn, pass along some portion of that cost to depositors through service fees and lower deposit account interest rates. The market-based approach makes the premium cost to depositors transparent. We should point out that no deposit insurance system along the lines of our proposed system currently exists.
7.5 ADOPTING RISK-RELATED PREMIUMS (CP 9)
There are additional considerations for deposit insurers that wish to adopt a risk-related premium (RRP) system aside from the technical issues discussed in section 7.1. These additional considerations involve the compatibility of the RRP system with supervisory standards for bank safety and soundness, banking laws, and the potential impact of a risk-related premium system on the deposit insurer’s ability to meet its target fund.
COMPATIBILITY WITH SUPERVISORY STANDARDS AND BANKING LAWS
One goal of a risk-related premium system is to encourage banks to adopt less risky business practices in the hope of reducing future bank failures and insurance losses. To provide these incentives the premium system must be sufficiently transparent that banks have a clear understanding of the incentives the system is trying to create. To avoid confusing and/or conflicting regulatory incentives the insurer should ensure compatibility of the risk-related premium system with supervisory standards and banking laws. Box 1 discusses potential incompatibility between a RRP system and supervisory treatment of bank capitalization, as measured by leverage ratios.
INTERACTION WITH ACHIEVING THE TARGET FUND
A second issue with the adoption of a RRP system is how the system might affect bank behavior, premium revenue, and the insurer’s plans for achieving a target fund. Upon adoption of an RRP system there is uncertainty about its effect on bank behavior and, consequently, premium revenue. The uncertainty in projections of future premium revenue is greater for a newly implemented RRP system than for a flat-rate premium system. While both flat-rate and RRP premium systems have uncertainty concerning the future assessment bases for banks, number of insured banks and intervening events such as changes in premium rates due to banking crises, the effect of RRP on bank behavior is difficult to anticipate. We recommend the deposit insurer weigh these uncertainties relative to its goals for achieving a target fund. Should achieving a target fund be a primary concern the insurer might consider adopting an RRP system subsequent to achieving the target fund. This would give the insurer a period of time to observe the effects of the RRP system on bank behavior, and by inference, premium revenues when achieving the target fund is no longer an urgent concern.
7.6 MEMORANDA OF UNDERSTANDING
No deposit insurer operates in a vacuum. All such institutions must work as part of the overall financial safety net in a jurisdiction. There should be formal arrangements in place for cooperation and information sharing and the legal framework governing the operations of the safety net structure must allow for the sharing of confidential information subject to appropriate safeguards and operative bank secrecy rules. Such arrangements are often contained in Memoranda of Understanding (MOUs) as discussed below.
7.6.1 WITH OTHER MEMBERS OF THE SAFETY NET
In normal times as well as in times of crisis there can be the need for real-time sharing of detailed information concerning deposit levels, conditions at a particular financial institution or other developments within the country’s economy. Such information sharing should be the subject of planning and agreements, with the agreements being as broad and specific as possible to minimize any possibility of delay in information sharing when needed. An example of such an agreement between a deposit insurer and the supervisory authority can be found at Appendix 14.5.
Information sharing should be tested as part of crisis preparedness which can make any shortcomings in the information sharing framework apparent (for example inadequate specificity of deposit information or differences in such information between supervisors and deposit insurers). Agreements should also allow for the sharing of resources, both human and financial, during a payout event as the deposit insurer may need additional capacity to complete its mission. Supervisors can be candidates for assistance during a payout but there may also be resources at other safety net member agencies (for example IT specialists) that could provide useful service to the deposit insurer as it prepares for and completes its work. It is important, however, for deposit insurers to be prepared to source such assistance from the marketplace and not rely solely on the availability of assistance from other safety net players who themselves may be fully employed in a time of financial distress in a jurisdiction.
7.6.2 WITH OTHER DEPOSIT INSURERS (CROSS-BORDER)
MOUs with foreign deposit insurers should be tailored to the specific circumstances of a given jurisdiction. A general agreement between deposit insurers providing for cooperation and high level information sharing may be sufficient for those deposit insurers without specific connections to the jurisdiction at issue (for example an agreement allowing cross-training opportunities and sharing of information on general deposit insurance initiatives at the MOU signatory agencies). It may also be appropriate to have such agreements allow for the signatory agencies to attend and observe or perhaps assist in insurance events such as payouts in each other’s jurisdictions (subject to the necessary confidentiality protocols).
Where there are cross-border institutions involved with two or more deposit insurers the need for more specific cooperation is clear. It is essential in such circumstances that there be robust MOUs in place that provide for the type of information and cooperation that could arise in an insurance event. If a financial institution in jurisdiction A closes and there will be an insurance event in that jurisdiction and that financial institution has either subsidiaries or branches in jurisdiction B the need for information sharing is qualitatively different than the situation where there is no connection between jurisdictions. There is not only the need for specific information about the event in jurisdiction A but there may be a need for information on interconnections between the cross-border institutions (for example, an institution in jurisdiction A is closed because of a fraud by a member of management which may require jurisdiction B to make clear in its communications that such person is or is not involved in the operation of the institution in jurisdiction B). Home-host agreements should be in place in all of these circumstances.
There is also a need for cooperation in communication on the insurance event so that the jurisdictions involved speak with one voice and do not create unnecessary confusion on what the impact in each jurisdiction will be from the regulatory actions. This is especially important in the age of social media where information and more importantly disinformation can spread quickly across borders. If there are different coverage levels of insurance in the jurisdictions involved there will need to be clear communication on what will happen to depositors in each jurisdiction and which deposit insurer will be responsible for any needed payouts. These issues can be addressed in the MOUs and tested by the affected deposit insurers through the use of crisis simulation exercises. An example of a cross-border MOU is contained in Appendix 13.1.
As an introduction to insurance fund management, we first discuss sources and uses of deposit insurance funds, followed by stakeholder interests, investment risks and, finally, investment policies. It should be noted that the determination of an appropriate investment policy should take into account all the expected claims on the fund, including not only operating expenses but also potential payouts or resolution costs that might be incurred.
8.1 SOURCES AND USES OF DEPOSIT INSURANCE FUNDS
The deposit insurer’s primary sources of revenue are insurance premiums and returns on the investment portfolio. Primary expenses are losses on failed-bank receiverships and operating expenses (employee salaries and benefits, expenses for fixed assets and other operating expenses). Positive net income (revenues minus expenses) can be distributed in four possible ways: 1) declared to be “excess premiums” that are credited towards future bank premiums, 2) remitted to the Ministry of Finance as “surplus revenue”, 3) retained by the insurer to increase capital (i.e., the insurance fund) and in some cases 4) paying taxes on insurer income. Which combination of net income distributions is used by the insurer is determined by government authorities and may be part of the deposit insurance law. We do not debate insurers’ approaches to net income distribution, rather, we only wish to acknowledge that there are multiple demands on the insurer’s profits and it may also be important to consider that some approaches could present conflicts of interest.
8.2 STAKEHOLDERS VERSUS SHAREHOLDERS
Deposit insurers sometimes refer to insured banks as “stakeholders”. This is an acknowledgment of bankers’ interest in deposit insurance and bank regulation. A stakeholder is defined as “an interested party”, e.g., someone interested in an organization’s success (failure). Insured banks have no equity ownership of public sector deposit insurers. In jurisdictions where deposit insurance is mandatory for deposit taking institutions, however, these institutions are more than interested parties and should be consulted regarding deposit insurance policy and premium setting in order to provide useful information of policy effectiveness and impact on banks. We are not arguing, however, that insured banks be part of the deposit insurer’s governance structure.
8.3 INVESTMENT PORTFOLIO RISK
Deposit insurers’ investment portfolios are exposed to two types of risk—credit and market. Credit risk is due to the possibility that debt security issuers default on interest and principal payments. Market risk includes changes in market prices for securities that adversely affect securities’ market value. Market risk arises from increase in interest rates offered on debt securities which reduces the present discounted value (market value) of promised coupon and principal payments, equity securities’ price reductions and changes in foreign exchange rates that adversely affect investments denominated in foreign currencies.
8.3.1 CREDIT RISK
Given the potential of unexpected demands on an insurance fund to meet insured depositors’ claims, insurers should place emphasis on maintaining fund value. For this reason, deposit insurers typically invest in securities issued by the domestic national government, and, in some cases, securities issued by foreign governments. To the best of our knowledge no public deposit insurer invests in private sector debt and equity securities.
8.3.2 MARKET RISK
Depending on the jurisdiction’s accounting practices, investment portfolio composition in terms of intended uses of securities classified as “held to maturity” (HTM) or “available for sale” (AFS) can affect portfolio value.63 Specifically, should the insurer sell a portion of its HTM securities portfolio, it would be required to restate the value of all HTM securities in the portfolio at fair market value as opposed to amortized cost. If interest rates have increased relative to those at the time of an HTM security’s purchase, its fair market value will be less than amortized cost. Adverse movements in interest rates will also reduce the fair market value of AFS securities. Reductions in debt securities’ fair market value due to market interest rate increases represent interest-rate risk (IRR) to the insurer.
In some jurisdictions the insurer is required to pay insured deposit claims in the currency in which the account is denominated and this exposes the insurer to foreign exchange rate (FX) ”market” risk. To mitigate FX, risk the insurer could maintain a portion of its investment portfolio in foreign currencies and/or securities denominated in foreign currencies. The proportion of the investment portfolio held in foreign currencies should be proportional to insured banks’ foreign denominated insured deposits.
Market risk can also be managed through financial hedges such as options and futures contracts. Deposit insurers have not, to the best of our knowledge, used financial hedges to manage market risk, however. This is likely due to strict limits on the types of financial investments deposit insurers are allowed to make. Since financial hedges can present significant risks to the investor if used incorrectly, deposit insurers should ensure they have utilized professional asset management services to assure they have access to sufficient expertise in the use of financial hedges before considering using such instruments.
8.3.3 LIQUIDITY RISK
In addition to credit and market risks, deposit insurers also face liquidity risk, i.e., the risk the insurer cannot pay incurring liabilities from maturing assets (the investment portfolio). Liquidity risk for deposit insurers is primarily due to the need for immediate, liquid funds to pay insured depositor claims. The insurer’s liquidity needs should be viewed from several perspectives—current, long term and economically stressful perspectives. Should current banking market conditions be benign, the insurer can anticipate few bank failures and low-to-moderate needs for liquidity. Conversely, should current market conditions indicate a high level of overall bank-failure risk, the insurer’s liquidity needs are heightened, and liquidity needs should be gauged relative to previous (or simulated) needs.
As a consequence of these several risks—credit, market and liquidity—the insurer’s investment policy should state investment priorities and consequently limits on portfolio composition in terms of security type, remaining maturity, issuer or credit rating. Further, portfolio performance and risk metrics should be specified, thresholds set and regularly monitored and reported to the insurer’s chief financial officer and Board of Directors.
Investment portfolio performance can be measured by portfolio yield (weighted average of securities’ yields), and portfolio value (amortized cost or fair value, as applicable). Default risk can be measured by the credit ratings of issuers, as provided by credit rating agencies. Interest-rate risk can be measured by duration gap analysis and interest rate stress simulations. Similarly, foreign exchange rate risk can be measured through FX stress simulations.
9. PREPARING FOR INSURED DEPOSITOR PAYOUTS (CP 15)
The reimbursement of insured depositors is a core function of any deposit insurer no matter its mandate. If it is not handled well, it can undermine confidence not only in the effectiveness of the deposit insurance system but potentially in the country’s entire financial sector. A well-executed reimbursement process can also limit the possibility of contagion risk to healthy banks.
There are certain prerequisites to the conduct of an effective reimbursement process. First, the deposit insurer must have the ability on a real-time basis to determine which deposits are insured and which are not using deposit records at each member institution that are maintained in a format agreed to between the deposit insurer and its member institutions (a single customer view format or its equivalent) (see Table 3 below). Second, there should be a focus on how best to facilitate quick access to depositors’ insured deposits, thereby limiting hardship to such depositors. This will require the deposit insurer to determine which accounts are insured and which accounts are excluded (for example accounts associated with criminal activity). Third, there is a need to provide real-time, ongoing accurate communication through multiple communication channels (for example, websites, print, radio, digital and other media) so as to meet all depositors’ expectations on the reimbursement process. There should also be a process in place for addressing claims by depositors whose deposits cannot be immediately paid out because of the lack of or inconsistent information on account records. Data cleaning and verification along with internal controls (for example, four-eyes process, logging of all critical information) are also essential to the conduct of a secure and accurate payout process.
Each work process should be tested in advance of any payout with back-up systems in place to avoid the risk of failure to the greatest extent possible. One way to test such systems is to do a payout simulation exercise. It may be possible to perform such a simulation using masked real banking data on depositors’ accounts in partnership with one of the member banks for the deposit insurance system.
Effective and efficient reimbursement to insured depositors requires coordination between the supervisory authority and deposit insurer. Such coordination can be the subject of a Memorandum Of Understanding between the parties (see example of such an agreement at Appendix 14.5). It is essential to have advance notification and agreement on critical issues (for example on which accounts should be excluded in the reimbursement process) and early access to depositor information which is crucial to the payout process. This allows the deposit insurer to assess the financial institution’s data quality at the time of payout. It is also essential that all information related to a payout is archived at the end of the process for future use and in compliance with record retention rules in place in the jurisdiction.
There can be some challenges to completing an efficient process that should be addressed in advance of any payout if possible.65 Most jurisdictions have unique customer identifier numbers (for example Social Security numbers in the United States) that can be used by financial institutions when opening accounts. In the absence of such a system it is important to be sure that accounts opened by the same individual at a financial institution can be aggregated at the time of payout to be able
to properly apply payment limits. Authorities should issue guidelines or regulations to ensure that all member institutions, including the smallest ones, can provide accurate deposit liability records, within a specific timeframe, for aggregation of depositors’ funds and when required by law or regulation (i.e., a “single customer view”).
The poor quality of an institution’s records or the systems supporting such records can hinder the ability of the deposit insurer to efficiently perform a payout 66 as can the complexity of the rules governing netting requirements in place in the jurisdiction.67 The deposit insurer should also be able to use whatever IT systems are in use at the member institutions and be able to integrate the information in those systems with the IT payout infrastructure in use. For deposit insurers that do not act as receiver or liquidator arrangements should be in place that allow the receiver or liquidator to assist the deposit insurer in the payout process (see Appendix 14.6 for an example of an agreement documenting such arrangements). There is also the need to be sure that impediments to prompt reimbursement are eliminated to the greatest extent possible. For example, elimination of the need for every depositor to file a claim for reimbursement should be considered as the deposit records
of the institution itself should in most circumstances be sufficient to establish ownership issues for the purpose of reimbursement.68 Requiring the filing of claims for reimbursement may in some circumstances disadvantage depositors in more remote areas. Complex set-off rules can also be a potential obstacle to a prompt payout while the use of interim payments can be a tool to speed at least a partial payment to insured depositors if delays in making complete payments arise. Where set-off is required in the payment process it should be clear that the application of such rules can be fully accommodated by both the banking system and deposit insurer’s IT systems.
It is essential that post-reimbursement processes be in place. An audit of the reimbursement process should be conducted by an independent party to confirm that appropriate internal controls have been applied during the reimbursement process, that reimbursements are accurate to the greatest extent possible and that accurate records of the reimbursement process are maintained. See IADI Core Principle 15, Reimbursing Depositors. Post-reimbursement processes may also include surveys of depositors to assess the degree of satisfaction or dissatisfaction with the handling of their insured accounts.
Table 3 is indicative only and should be completed using the governing laws, regulations and policies of the deposit insurer. It is a table designed for use in designing a Single Customer View (SCV) protocol with member institutions. It reflects information on insured accounts, but a similar table could be developed for calculating uninsured accounts and/or amounts or other non-compensable deposits.
TABLE 3 - INDICATES FIELDS FOR ALLOWING DEPOSIT INSURER TO DETERMINE INSURED ACCOUNTS PAYOUT FROM MEMBER INSTITUTION'S RECORDS
The use of paying agent banks can be an effective way to complete a payout. Clear requirements for approval of agent banks are essential, with such banks being selected in advance for consideration at the time a payout is imminent at which time the specific payout bank will be chosen. Geographical considerations should be taken into account (for example, the paying agent bank has a number of branches in the areas where most depositors of the closed institution were located) as well as adequacy of systems for handling a payout (for example adequate IT infrastructure to take on the payout tasks in addition to normal business operations of the paying agent). The supervisory authority must be consulted before approving a specific institution as a paying agent to be sure there are no supervisory concerns that would be implicated in the choice of a specific institution for that role. In consultation with the paying agent the deposit insurer should itself determine what payout methods will be used and plan all the logistics of the operation (for example how will cash deliveries be set up), including how the payout process will be monitored and all the reports to be required of the paying agent. It will also be necessary for the deposit insurer to establish appropriate financial sub-accounts to accurately account for all the costs associated with a particular payout including compensation to paying agent bank and to keep those costs separate from the overall account of the deposit insurer. There should be testing of the transmission of payout data from the deposit insurer to the paying agent bank which can be completed in advance of any need for a payout using dummy or masked files.
9.2 ALTERNATIVE METHODS FOR PAYING CLAIMS
Payment through agent banks can be made to a depositor in a number of ways, either by an electronic transfer, a cash payout, the use of a cheque or the transfer or opening of a new account. Increasingly electronic transfer of funds should be available using a web-based platform specifically established for such purpose or by making use of secure web-based tools already in use in the jurisdiction for payment. It may be necessary in some unusual situations to set up a way to deliver cash to a depositor and if such circumstances exist (for example many depositors unable to physically access their cash payments by traveling to a paying agent bank) there should be a system established to facilitate a safe delivery of cash to affected persons. Cheques can be mailed to depositors or be made available at the paying agent bank or payment cards can be used as a form of payment. In the case of small balance accounts, it may be possible to use e-wallet technology or other automatic transfer options if available within a jurisdiction.
The paying agent bank can also make a new deposit account or an existing account at the paying agent institution available to the claimant. It is also possible for a transfer to be made directly to a depositor’s account at a bank other than the paying agent bank if requested.
9.3 DETERMINING INSURED AMOUNT (ISSUES OF SET-OFF, AGGREGATION OF ACCOUNTS INCLUDING TREATMENT OF JOINT ACCOUNTS)
The determination of the insured amount due to an individual depositor is most often determined by the legal framework in place. However, there are situations where, although the law governing the deposit insurer’s operations may specify that a certain type of account is insured, there is no specific guidance in the law as to how to appropriately calculate the insurance payment that would be due to a depositor if a member institution is closed. In such circumstances, then, it is essential that the deposit insurer establish clear rules to be applied in various situations for the benefit of member institutions as well as depositors.
RULES GOVERNING SET-OFF
Set-off or netting is the process of determining what obligations are owed to a member institution by a depositor with an insured account and then, depending on the rules in effect, either reducing the amount of any insured deposit payout by the full or some lesser amount of such obligations. In a jurisdiction where it is common for a depositor to have all banking relationships with just one institution it may be that a depositor would have various accounts, e.g., a mortgage, a car loan or a line of credit in place at the institution that houses all their accounts. In such cases the process of set- off can be time consuming and may in fact be inconsistent with a depositor’s expectations about their accounts. An example of the complexities surrounding set-off follows.
Mary has all her accounts at First Bank. She has a savings account, a car loan, a mortgage and a line of credit. At the time of the closing of First Bank she has a balance in her savings account of $100,000 USD (the amount of the insurance limit) as well as a car loan of $5,000, a mortgage of $50,000 and a line of credit of $1,000. She has been saving for tuition payments for her children as well as a planned vacation in the next few months. All of her loans are current, i.e., there are no past due payments.
First Bank is closed and the deposit insurer has to do a pay-out to insured depositors. Assuming that full set-off is in place for Mary’s accounts, the deposit insurer would have to gather all the information on the balances not only on Mary’s savings account as of the date of closure but also all the loans in place. In determining the amount of the pay-out, the deposit insurer would look at the amount of the savings account and then subtract all the loans Mary has to arrive at a payout to her of 44,000. Although all her loans would now be paid in full, she would no longer have access to her savings in the amount prior to the bank’s closure of 100,000. This might significantly impact Mary’s plan for how she would pay tuition or pay for her planned vacation which could be contrary to her expectations and thus create some dissatisfaction with the deposit insurer. If no set-off was in place the deposit insurer would pay Mary 100,000 without even having to consider whether she had any loans at the closed institution.
Let’s assume Mary was past due on her car loan in the amount of 1,000 but was current on her other loans. If the deposit insurer was required to subtract past due loans from Mary’s insurance payment, then only that loan would have to be taken into account in determining the deposit insurer’s obligation. It would also not be unreasonable for Mary to expect that any past due obligations at the bank would be collected by the authority closing the bank before making payment on her insured account. Importantly, unlike past-due loans, the resolution authority may well be able to make use of Mary’s performing loans in its completion of the closing of First Bank by selling those loans to another financial institution thus reducing the amount of funds that would have to be paid out in its resolution of the institution.
If no set-off is in place then the deposit insurer does not have to consider anything other than the deposit records associated with an insured depositor. However, in a jurisdiction where the payment of troubled loans after a bank closing is challenging it may be that the closing authority would want to collect as much as possible on such loans to lower its cost of resolution. This would involve a policy judgment depending on the situation in effect in a given institution. Regardless of whether set-off is used in a jurisdiction it is essential that the rules governing such a process be clearly set forth in the law or by regulation.
AGGREGATION OF ACCOUNTS
In its simplest formulation deposit insurance is most often per depositor, requiring the aggregation of all accounts held by a depositor in determining the application of the insurance limit to that depositor’s accounts. Thus, if the insurance limit is 100,000 and the depositor has three accounts each with a balance of 100,000 the amount to be paid to the depositor if the financial institution closes is 100,000, with the remaining 200,000 uninsured, entitling the depositor to a claim in that amount in the liquidation of the bank’s assets.
However, it is not uncommon for deposit insurance limits to apply per depositor per account held in a separate capacity. For example, Mary could have a savings account insured up to $100,000 and then an account in a separate capacity such as a retirement account that would be insured without aggregation with her savings account, thereby providing her with $200,000 of insurance. All such rules governing the treatment of specific types of accounts under the deposit insurance scheme should be clearly understood by the member institutions themselves whose staff most likely will be the in-person contact for a depositor seeking to open an account.
Joint accounts are a common situation where the rules of aggregation should be clear. This is necessary to avoid any confusion on the part of depositors or member institutions. There are several ways to treat joint accounts for purposes of applying the insurance limit. Such accounts could be deemed separately insured without limit, thereby allowing a depositor to open multiple joint accounts and thereby avoid the insurance limit for such accounts. Thus, using the example of Mary at First Bank, she could have an individual account and then multiple joint accounts with each such account being separately insured. This would, however, have the effect of allowing a depositor to by-pass the insurance limits easily by use of a simple deposit structure.
More commonly joint accounts are insured separately from individual accounts but only up to the insurance limit for each joint account holder. Thus if Mary in the example above had an individual account of 100,000 and two joint accounts with her interest in the two accounts totaling 150,000 (i.e. Mary and John with a balance of 100,000 and Mary and Paul with a balance of 200,000) then Mary would have a total of 200,000 in insured deposits, with 50,000 being uninsured (100,000 of individual coverage and 100,000 of insured coverage in the two joint accounts, leaving Mary with uninsured funds of 50,000; John would have 50,000 and Paul would have 100,000 of insured funds in the joint accounts).
As these examples illustrate, aggregation requires that the deposit insurance limit be applied once the total of deposits to be aggregated is calculated.
9.4 ACCESS TO REAL-TIME INFORMATION
As has been stated previously it is necessary that a deposit insurer have access to information on the structure of accounts at member institutions on an ongoing basis. This is essential to allow a deposit insurer to understand not only what its obligations might be for purposes of completing a payout but also to understand and verify the calculation of the deposit insurance premiums paid by member institutions. During a payout there is also the need to be able to update information promptly to inform depositors of the status of the payout of their insured funds.
The information provided by member institutions should be verified by the deposit insurer working closely with the supervisory authority. It is also a good practice to test the payout capability of the deposit insurer by using information from a member institution even if the laws in place may require the masking of individual depositors’ names for such a test. A cooperative effort with one or more member institutions to test payout capability is an essential element of preparedness for a deposit insurer. Development of a framework for such testing may require preparation of a payout simulation handbook.
As noted previously the use of legal identifiers is essential to the conduct of an efficient and effective payout. Each account that is opened at a member institution should be associated with a legal identifier (where such systems exist this could be a national identification number) that allows the identification of the account holder for all purposes, including the aggregation of accounts. If there is not a universal legal identifier system in place in a jurisdiction then the deposit insurer and member institutions must agree on a system that will allow for such aggregation in an individual member institution.
10. PUBLIC AWARENESS STRATEGIES (CP 10)
A significant responsibility of a deposit insurer is to make the public aware of the benefits and limitations of deposit insurance and to periodically measure the level of such awareness as set forth in Core Principle 10:
PRINCIPLE 10 – PUBLIC AWARENESS
In order to protect depositors and contribute to financial stability, it is essential that the public be informed on an ongoing basis about the benefits and limitations of the deposit insurance system.
Achieving an appropriate level of public awareness requires the deposit insurer to have a strategy in place to inform different members of the public on a continuous basis of the elements of the deposit insurance scheme and to increase the awareness generally of the existence of the deposit insurer and its role in the financial safety net. The strategy should distinguish between ongoing efforts in normal times and the extraordinary efforts that will be undertaken in times of stress, including the efforts that will be undertaken if there is a payout of insured deposits. (See Outline of a Public Awareness Strategy and Sample Survey Questions, Appendix 14.3). As noted in the Outline, public awareness is handled differently in times of a crisis or insured deposit payout. During such times there may be a need for specific webpage entries on the payout, an increased capacity for the deposit insurer to handle calls and inquiries and the development of specific messaging around the crisis situation.
A public awareness strategy should define the target groups for the strategy (e.g. men, women, youth, the elderly), define the methods the strategy will use to achieve its goals, adopt a plan for how often periodic messages on the scheme should be undertaken and determine how the effectiveness of the strategy will be measured. In addition to periodic messages such as public service announcements or other forms of public outreach such as contests or appearances at relevant public events, there should be a robust public awareness presence on the deposit insurer’s website with the capability to provide answers on coverage levels and rules for the general public as well as employees of member institutions.
Financial institution employees are often the first introduction a depositor may have to the particulars of a country’s deposit insurance scheme. For that reason a public awareness strategy should include a plan for training those employees and providing detailed, easy to read brochures for use by the financial institutions with their customers. Such a plan could be developed in partnership with the local banker’s association.
A plan for depositor outreach that goes beyond the deposit insurer’s website should also be developed in order to reach all depositors. Such outreach can make use of the brochures developed for use by financial institution employees as well as public service announcements on social media, television, radio and print media. Depositor outreach should be an ongoing effort and should be increased in times of financial sector stress to counter the possibility that a lack of confidence in the financial sector might encourage depositor runs.
Financial literacy efforts that target all members of society should include information about deposit insurance and can be undertaken with the help of other financial regulatory bodies as well as schools serving all ages. The deposit insurer can contribute to a financial literacy curriculum with targeted materials that can be used by educators at all levels. Groups or public agencies involved in consumer protection efforts can also be part of a deposit insurer’s public awareness strategy.
10.2 MEASURING THE EFFECTIVENESS OF PUBLIC AWARENESS STRATEGIES
Assessing the effectiveness of the deposit insurer’s public awareness efforts is an important part of implementing an effective strategy. The deposit insurer can undertake periodic public wide surveys of depositors and other key stakeholders but also engage regularly in surveys of member institution employees and visitors to the deposit insurer’s website to gauge the level of knowledge of the rules applicable to the deposit insurance scheme as well as the role and functioning of the deposit insurer. The public surveys should be conducted on a periodic basis on a schedule adopted by the Board. The surveys should measure general public awareness and knowledge of the deposit insurance scheme, identify target groups where there is a need for increased awareness and identify the most effective methods for communicating with the public about deposit insurance.
If there is a payout or transfer of insured deposits the deposit insurer can ask depositors about their experience with the process. The feedback on the process should inform future public awareness efforts and contribute to improvements in the messaging undertaken by the deposit insurer going forward.
10.3 DEVELOPING COMMUNICATION PROTOCOLS
Communication protocols should be developed for ongoing communication and for periods of stress in the financial sector. In addition, protocols for communicating during a payout or resolution action should also be developed. The target groups for the two types of communication have some overlap but also will vary in that specific information will have to be provided during the payout process to the depositors of the failed bank along with continuing the ongoing information to depositors generally. A call center may have to be activated or enhanced during a payout and guidance to those answering telephone inquiries will have to be developed to ensure that accurate, uniform responses are being provided to all those who call. Media will be important partners in any communication strategy but they play a particularly important role in times of crisis when the need for correct and timely responses to depositors is essential.
The deposit insurer’s website should be kept up to date and should allow visitors to access the information needed to determine if their deposits are insured. Depending on the complexity of the rules governing coverage this may require the development of a tool that would allow a depositor to input various pieces of information about accounts held at a member institution to calculate any uninsured amounts. Frequently Asked Questions (FAQs) should be developed that would provide
accessible answers to common deposit insurance inquiries such as the level of coverage and whether such coverage applies separately to accounts held in different capacities.
If there is a payout there will most likely be a need for one or more press conferences as well as periodic press releases. There can be a separate section of the deposit insurer’s webpage devoted to information about the payout, including the compensation process, that can be accessed by interested parties. The progress of the compensation process should be regularly updated.
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Acknowledgments
We would like to thank the people who provided comments and suggestions on earlier drafts of this document. These individuals have worked at a variety of deposit insurers internationally, and offered their unique perspectives: Kevin Chew, András Fekete-Győr, Hugo Libonatti, Lee Yee Ming, Cristina Orbeta, Steven Seelig, and Silvana Sejko. We benefited greatly from these individuals’ suggestions. Any remaining errors are ours alone.