# PUBLIC-POLICY OBJECTIVES

#  FOR

# DEPOSIT INSURANCE SYSTEMS

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# Abstract

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# Countries base their deposit insurance systems on a variety of public-policy objectives. After consultation and analysis, the Subgroup on Public-Policy Objectives identified a number of common objectives that may be classified under three broad categories: 1) those contributing to the stability of the financial system; 2) the protection of less-financially-sophisticated depositors; and 3) other. Although countries often choose similar objectives, analysis suggests that there is variation in how they are achieved. Thus, policymakers should endeavour to understand the trade-offs and implications associated with particular objectives, and should structure their deposit insurance systems accordingly. It is also important to revisit these objectives over time.

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# PUBLIC-POLICY OBJECTIVES

# FOR

**DEPOSIT INSURANCE SYSTEMS**

The following represents the work of the Subgroup on Public-Policy
Objectives.[^1] The paper focuses on: 1) the identification of
public-policy objectives used by different countries; 2) the trade-offs
associated with particular public-policy objectives; and 3) the
structural and other implementation issues that may arise when
particular public-policy objectives are chosen.

**Background**

The development of public policy by governmental bodies and officials
involves the selection of goals and the means of achieving them within a
specified context. Public-policy objectives, which involve formal and
informal expressions of normative intent, provide purpose and focus.
These objectives can be stated explicitly---for example, through a
legislative mandate---or implicitly by the way a particular activity is
conducted or structured. Implicit public-policy objectives by their
nature can be more difficult to identify since they must be inferred
from the way activities are undertaken or administered. At times, the
public-policy objective may result in a decision not to act; at other
times, multiple public-policy objectives may be pursued through a single
activity.

The implementation of a public policy may lead to unintended or
unforeseen consequences. In certain cases, such unintended consequences
may be inevitable; in other cases, unintended consequences may be
addressed by restructuring the policy and activity to make it more
consistent with the original intent of policymakers.

Although the determination of public-policy objectives is the
responsibility of governments, the private sector often plays a role in
the implementation and administration of particular public policies.
With respect to deposit insurance, many countries have privately
operated systems that fulfill public-policy objectives. The choice of
how a deposit insurance system is to be operated depends on factors that
are unique to each country.

The selection of public-policy objectives is often a complex process.
The Financial Stability Forum\'s Working Group on Deposit Insurance (the
Working Group) suggested in its *Background Paper* that when countries
select public-policy objectives, they should take certain conditions
into consideration such as the state of their economy, the legal and
supervisory framework, the structure of the banking system, the quality
of accounting, regulatory and auditing standards, and the disclosure
regime.[^2] The Working Group also suggested that for countries to
fulfill their public-policy objectives, there should be congruence
between the objectives and how the deposit insurance system is
structured. Although this paper does not examine structural issues
specifically, it is important to emphasise that the effectiveness of the
deposit insurance system will depend on the level of congruence or fit
between public-policy objectives and structures.

A variety of methods exist for determining public-policy objectives. One
method suggested by the Working Group is for policymakers to begin with
a public-policy paper. The analysis contained in the paper should take
into account relevant conditions referred to above. The paper also could
set out the key attributes and elements that are important to a deposit
insurance system, so as to determine the mandate and the powers to be
given to the deposit insurer. As well, the paper should outline the role
of the deposit insurer within the financial safety net and the deposit
insurer's relationship with the other participants in the regulatory and
supervisory regime. The paper would form the basis for discussion and
help policymakers formulate their decisions.

### Public-Policy Objectives for Deposit Insurance Systems

Public-policy objectives vary according to national conditions.
Countries may structure their deposit insurance system to achieve one or
more objectives. These objectives may shift over time in response to
changes in economic, financial and/or social circumstances. Policymakers
may alter the mandate, roles and responsibilities of the deposit
insurance system in response to these changes.

To aid its deliberations, the Subgroup examined information provided by
members of the Working Group on the public-policy objectives underlying
their deposit insurance systems. The Subgroup also considered
information provided through the Working Group\'s public Web site and
Outreach Sessions. As a result of this consultative process the Subgroup
identified three broad categories of public-policy objectives. First,
contributing to financial system stability; second, protecting
less-financially-sophisticated depositors; and third, other objectives.
In certain circumstances some objectives may be closely related to, or
components of, broader objectives. A general discussion of these broad
categories follows.

**Contributing to financial-system stability**

A common public-policy objective for deposit insurance systems is to
contribute to the stability of a country's financial system. This
objective is based on a concern that depositors may lose confidence in
an institution under certain circumstances.

*Minimising the risk of runs*

Without deposit insurance there is a greater likelihood that depositors
might "run" by removing their deposits from an institution in response
to difficulties---either real or perceived---at that institution. Once a
run begins at one institution, it may lead to runs at
others---regardless of their condition---as depositors may find it
difficult to differentiate between sound and unsound institutions. This
is often called the contagion effect. As a result, sound institutions
may face difficulties when they are compelled to liquidate their asset
portfolios, often at depressed prices, in order to meet withdrawals.

The ability of a deposit insurance system to stem or avoid bank runs
depends on the extent to which depositors feel protected from loss in
the event of a failure. The level of coverage, the speed with which
insured deposits are repaid, and the credibility of the guarantee will
affect whether the deposit insurance system is capable of enhancing
financial stability. However, a policy trade-off exists between
maximising financial stability through a blanket guarantee and the
problem of maintaining market discipline. Over the long term, financial
stability may be enhanced by limiting coverage and fostering market
discipline since distortions in market incentives may be lessened.

It is important to note that a deposit insurance system on its own
cannot ensure financial system stability. This is especially true in
cases of a systemic crisis. A deposit insurance system is more effective
when it is part of a coordinated financial safety net that includes,
among other things, supervisory and regulatory arrangements and
lender-of-last-resort facilities. Bankruptcy and insolvency laws and a
government's economic policies also will play a crucial role in
mitigating and avoiding problems in the financial sector.

*Creating formal mechanisms for resolving failed institutions*

The introduction or reform of a deposit insurance system may be linked
to a country's attempt to put in place laws and mechanisms that deal
with failed institutions. Experience suggests that the failure of
depository institutions must be handled in unique ways to deal with the
tendency of troubled institutions to deteriorate rapidly, while
minimising adverse effects on the overall financial system. The
introduction of deposit insurance may be linked to the creation of a
country's failure-resolution framework.

*Contributing to an orderly payments system*

Deposit insurance helps to promote financial stability by contributing
to the smooth functioning of the payments system. Deposits allow
individuals and businesses to save and withdraw money when it is needed.
By promoting confidence in the system, deposit insurance facilitates the
smooth transfer of deposits between parties. For the payments system to
function, depositors must be certain that their money on deposit is as
sound as currency.

In addition, some deposit insurance systems are able to provide a form
of emergency financial assistance, which may involve guaranteeing the
payment transactions of troubled institutions. Such assistance may help
to avoid interruptions in payment and settlement flows. In so doing,
such assistance provides time for safety-net participants to devise
solutions to resolve troubled institutions.

*Resolving a financial crisis*

Deposit insurance systems are often introduced when a country is
undergoing or has undergone a period of significant financial
instability. When problems within the financial sector occur, deposit
insurance facilitates the ability of institutions to maintain a stable
deposit base and is a means of assuring depositors that their funds are
secure.

There are certain issues that should be considered when a deposit
insurance system is introduced. As mentioned earlier, a deposit
insurance system by itself cannot restore financial stability. In
addition, deposit insurance will be more effective when it is introduced
as part of a comprehensive framework that includes sound macroeconomic
policies, regulatory and supervisory arrangements, legal frameworks, and
lender-of-last-resort facilities. These statements are valid regardless
of whether the financial system is in crisis.

A deposit insurance system that is introduced to avert short-term
financial instability may lead to long-term problems if issues such as
moral hazard are not addressed.[^3] Mechanisms exist that minimise such
costs, although they may be difficult to introduce during periods of
financial instability.

**Protecting less-financially-sophisticated depositors**

An oft-cited public-policy objective for deposit insurance is the
protection of less-financially-sophisticated depositors, who often are
distinguished by the small size of their deposits.
Less-financially-sophisticated depositors are protected for the
following reasons. First, deposit insurance protects individual
depositors against the consequences associated with the failure of an
insured institution. Second, the provision of deposit insurance relieves
insured depositors of the difficult and complex task of monitoring and
assessing the condition of their financial institution. The opaqueness
of information on depository institutions makes it difficult, if not
impossible, for less-sophisticated depositors to obtain and analyse the
financial condition of these institutions. This is often not the case
for sophisticated depositors and other general creditors. As a result,
less sophisticated depositors may be at an informational disadvantage. A
deposit insurance system can help address the inequity that exists
between sophisticated and unsophisticated creditors, and as a result may
help improve discipline on institutions.

If the main public-policy objective is to protect
less-financially-sophisticated depositors, then the level of coverage
may be such that sophisticated depositors will run when an institution
is perceived to be in trouble. This is the nature of the trade-off
between choosing financial stability as a public-policy objective and
choosing protection of less-financially-sophisticated depositors.[^4]
Conversely, limited coverage may provide an incentive for
financially-sophisticated depositors to exert market discipline, which
helps constrain overly risky behaviour by insured institutions.

### Other public-policy objectives

Although financial stability and the protection of
less-financially-sophisticated depositors are the primary objectives of
numerous deposit insurers, some countries have identified other
public-policy objectives as important to their system. In some cases,
these may be subsidiary objectives or by-products of the pursuit of
financial stability or the protection of less-financially-sophisticated
depositors. What follows is a sample of some of the less prominent
public-policy objectives identified by commentators and the Working
Group.

*Redistributing the cost of failures*

In countries where there is no formal deposit insurance system the cost
of protecting depositors often falls on the government. Establishment of
an explicit deposit insurance system can reduce the government's
financial obligation for such protection by limiting coverage and by
providing a mechanism through which surviving institutions may cover all
or a portion of the costs associated with resolving failures. However,
the ability of surviving institutions to contribute to the cost of
failures will depend on their financial condition. It may be necessary
for the deposit insurer to adjust premiums to reflect the remaining
institutions' ability to contribute. The government also may have to
contribute to part of the cost, at least in the short term.

*Promoting competition in the financial sector by reducing competitive
barriers in the deposit-taking industry*

By facilitating the entry of new firms into the deposit-taking industry
and by helping smaller institutions compete for deposits against larger
institutions, deposit insurance may promote competition. In the absence
of deposit protection, depositors are likely to prefer using large,
well-known institutions that are perceived to be less risky. This
perception reflects a number of factors. First, large institutions may
have more-diversified portfolios than smaller institutions. Second,
larger institutions may be protected by an implicit government guarantee
because they are considered to be too big to fail. Third, such
institutions may have a long history with a high level of brand and
franchise awareness among the public. The benefits of encouraging new
entry and competition may be improved economic efficiency, lowered
interest rates and spreads, and increased investment and economic
development.

The adoption of this objective may require adjustments in the structure
of the deposit insurance system to address issues such as moral hazard.
For example, a country may opt for generous coverage in order to
encourage the formation of new institutions. However, generous coverage
may require stronger supervisory discipline to compensate for any lost
market discipline, as well as other measures to control risks to the
deposit insurance system. This public-policy objective may have
implications for which institutions are eligible for membership in the
deposit insurance system.[^5] In addition, a focus on promoting
competition may compromise the ability of risk-minimising deposit
insurance systems to carry-out their mandate. In this case the
public-policy objective may conflict with the mandate of the deposit
insurer.[^6]

*Encouraging economic growth*

The introduction of deposit insurance may encourage the flow of funds
into depository institutions, thereby providing the basis for lending
and investment. In addition, the risk premium depositors require on
their funds may decrease, which may allow insured institutions to lower
their lending rates. Lower financing costs, in turn, may stimulate
investment and other economic activity. However, it should be noted that
deposit insurance can only indirectly stimulate economic growth.

*Reducing the effect of a recession*

One of the benefits of deposit insurance is that it can mitigate the
consequences of failures of insured institutions on depositors. This
benefit, in turn, may be particularly important during a recession.
However, the contribution made by the establishment of a deposit
insurance system to solving macroeconomic problems, such as a recession,
is limited.

*Facilitate the enactment of legislation, regulation and supervisory
regimes*

The establishment of a deposit insurance system may provide the impetus
for legislators to overcome political barriers to institute other
reforms as needed to maintain a sound financial system. The drawback of
pursuing this objective is that the resultant framework eventually
developed may only reflect the specific issues associated with deposit
insurance, and may not be sufficiently comprehensive to contribute to
overall financial stability.

*Facilitate the transition from a blanket guarantee to limited coverage*

Countries may introduce an explicit, limited-coverage deposit insurance
system as a way of facilitating the transition away from a full deposit
guarantee provided by the government or other public entity.[^7] In such
cases, deposit insurance systems may allow governments to reduce
coverage, and may provide a mechanism for managing the required change
in public and market attitudes toward deposit protection. The successful
implementation of this public-policy objective requires a well-developed
transition plan, a commitment to limited coverage, and a period of
relative financial stability.

### Conclusions

-   Before structuring or modifying a deposit insurance system,
    policymakers should identify the public-policy objectives they are
    trying to achieve and the trade-offs involved.

-   Public policies should address the specific needs and conditions of
    the country.

-   The choice of public-policy objectives should be guided by a
    country\'s contextual conditions, including: the state of the
    economy; the legal and supervisory framework; the structure of the
    financial system; the quality of accounting, regulatory and auditing
    standards; and the disclosure regime. As time passes and conditions
    change, a country's public-policy objectives may need to be adjusted
    to account for the new circumstances. In many countries a process
    exists for periodically reviewing their deposit insurance system's
    public-policy objectives. In this way, countries can ensure that
    their deposit insurance system remains consistent with economic and
    social conditions, and is better able to deal with the challenges it
    encounters.

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-   The structure of the deposit insurance system should be consistent
    with a country's chosen public-policy objectives. Public-policy
    objectives can be stated explicitly---for example, through a legal
    mandate---or implicitly---for example, by the way the system is
    structured. Implementation of an effective deposit insurance system
    involves understanding all of the relevant public-policy objectives
    and their implications, and structuring the scheme accordingly.

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-   Many public-policy objectives for deposit insurance systems exist.
    Although some objectives are more well-known than others, countries
    choose their objectives according to their country-specific goals
    and circumstances.

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-   Although the determination of public-policy objectives is the
    responsibility of governments, the private sector often plays a role
    in the implementation and administration of particular public
    policies. With respect to deposit insurance, many countries have
    privately operated systems that fulfill public-policy objectives.

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-   In practice, policymakers may present their objectives in a paper,
    such as a consultation document. This paper could contain analyses
    of country conditions and set-out key attributes and elements of the
    deposit insurance system. Consideration also should be given to the
    deposit insurer's role within the financial safety net and its
    relationship to other safety-net participants.

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-   Policymakers should review periodically the objectives and structure
    of the deposit insurance system and make changes as appropriate.
    Such a review may be needed in response to changes in economic,
    financial and/or social circumstances. Policymakers may alter the
    mandate, roles and responsibilities of the deposit insurance system
    in response to these changes.

[^1]: The Subgroup on Public-Policy Objectives is comprised of
    representatives from Canada (coordinator), Jamaica, Mexico,
    Philippines, and the International Monetary Fund.

[^2]: Financial Stability Forum Working Group on Deposit Insurance, *A
    Consultative Process and Background Paper*, June 2000.

[^3]: These issues are discussed in the papers on moral hazard and
    transitioning.

[^4]: See the papers on moral hazard and coverage for further discussion
    of these issues.

[^5]: See the paper on membership.

[^6]: See the paper on structure and organisation.

[^7]: See, the paper on transitioning*.*