**SITUATIONAL ANALYSIS:**

**CONDITIONS AND IMPLEMENTATION CONSIDERATIONS**

### Abstract

It is important to conduct a comprehensive situational analysis when
considering the introduction of a deposit insurance system or when
planning to alter an existing deposit protection arrangement. In
conducting such an analysis, the economic and institutional conditions
and their effect on the alternatives available for a deposit insurance
system must be considered. Among the conditions that should be taken
into consideration are the state of the economy including, current
monetary and fiscal policy; the state and structure of the financial
system; the legal framework; the state of the regulatory and supervisory
systems; and accounting and disclosure regimes. Although it is
understood that in many cases conditions are not perfect, it is
important to have a process to evaluate the alternative deposit
insurance systems available and how these alternatives are affected by
the economic and institutional structure of the country. Through a
situational analysis, gaps between existing conditions and
more-desirable situations can be identified.

**SITUATIONAL ANALYSIS:**

**CONDITIONS AND IMPLEMENTATION CONSIDERATIONS**

This paper emphasises the importance of conducting a comprehensive
situational analysis when considering the introduction of a deposit
insurance system or planning to alter an existing deposit protection
arrangement.[^1] In conducting such an analysis, the economic and
institutional conditions and their effect on the alternatives available
for a deposit insurance system must be considered. Among these
conditions are the following: the state of the macroeconomy, current
monetary and fiscal policy, the state and structure of the financial
system, the legal framework, the strength of prudential regulation and
supervision, and accounting and disclosure regimes. Although in many
cases conditions may not be perfect, it is important to have a process
to evaluate the alternative deposit insurance systems available and how
these alternatives are affected by the economic and institutional
structure of the country. Through a situational analysis, gaps between
existing conditions and more-desirable situations can be identified.

To better understand the process, the experience of countries that have
considered adopting, or significantly altering, deposit insurance
systems were analysed. In addition, consideration was given to
understanding the relative importance of these conditions and whether
there are some basic criteria that should be satisfied before adopting a
deposit insurance system.

**Alternatives for Deposit Insurance Systems**

The first step in establishing or significantly modifying a deposit
insurance system is for policymakers to determine their public-policy
objectives.[^2] Policymakers then face a wide range of possible
alternatives for the design of a deposit insurance system.[^3] These
include: the structure of the organisation---public, private, or
jointly-administered systems; and the basic powers---paybox systems,
which reimburse depositors on the instruction of another authority, or
risk-minimising systems with greater capabilities to assess and manage
risks. Policymakers should seek to ensure that an effective deposit
insurance system is instituted, consistent with both the country's
economic and institutional settings and aligned with the public-policy
objectives they are attempting to achieve.

**Methodology to Analyse the State of Country Conditions**

The methodology to assess the state of country conditions flows from the
Strategic Analysis Model, which begins with the determination of the
public-policy objectives, including the key attributes of the system
desired.[^4] After the public-policy objectives have been identified,
policymakers should conduct a situational analysis of the conditions in
their country. These conditions include: the macroeconomic environment,
including current monetary and fiscal policy; the soundness of the
financial system; the state of the legal, regulatory and supervisory
systems; the quality of accounting; and the state of the disclosure and
auditing regimes. The analysis should expose the strengths, weaknesses,
opportunities and threats related to the conditions, and identify any
changes necessary for the construction of an effective deposit insurance
system.

If existing conditions are incompatible with the public-policy
objectives, then either the objectives will have to be modified or
different options for the design or structure of the deposit insurance
system should be explored. Following the development of public-policy
objectives that are aligned with the country\'s economic conditions and
institutional framework, the next step is to develop a strategic plan
for implementation.

**Analysis of Conditions**

**Macroeconomic conditions**

An important consideration in a situational analysis is the
macroeconomic condition of the country, including its current monetary
and fiscal policy. This is important since the macroeconomy can affect
the financial system and influence the effectiveness of the deposit
insurance system. Although macroeconomic stability is important for the
successful implementation of a deposit insurance system, the boundaries
between propitious and unpropitious macroeconomic conditions may be
difficult to determine *a priori*.

Concerns about macroeconomic conditions often result in a loss of
confidence in the entire financial system, which is difficult to restore
through a single instrument such as deposit insurance. A loss of
private-sector confidence is likely to result from the overall economic
situation and the policy stance of the government, rather than
more-narrow concerns about the state of the banking system. The
introduction of a deposit insurance system, by itself, to protect
depositors cannot address the basic causes of the macroeconomic
deterioration. A deposit insurance system by itself cannot prevent a
banking crisis, or cure one that has already begun. If introduced
prematurely, a deposit insurance system can become so discredited that
its reintroduction may be impractical when macroeconomic conditions are
more favourable.

If the economic system is relatively stable, then the introduction or
enhancement of a deposit insurance system is more likely to be effective
in strengthening public confidence. That is, the failure of one
depository institution will not necessarily spill over and affect public
perceptions about the soundness of other depository institutions.[^5]

**State of the financial system**

A situational analysis will require an assessment of the soundness of
the banking system, including a detailed assessment of the condition of
the depository institutions within that system and the extent of their
problems. Factors that should be analysed include: capital, liquidity,
credit quality, and risk-management policies and practices. An
assessment also should be made as to whether these problems are confined
to individual institutions or are likely to be systemic in nature. The
issue is not whether there are unsound depository institutions in the
system, but whether the banking system as a whole is sound.

The establishment of an effective deposit insurance system is much more
difficult if underlying fundamental financial-system stability issues
have not been addressed. Early introduction of a deposit insurance
system, for example, could result in incentives for insolvent and
illiquid depository institutions to compete for deposits by raising
interest rates. Depositors, unconcerned about the financial health of
the depository institutions because of the deposit insurance system, may
shift resources from relatively risk-averse depository institutions to
those adopting more-risky policies. This shift could increase the
eventual cost of restructuring. It also is possible that policymakers,
when faced with an insolvent banking system, may wish to combine the
introduction of a deposit insurance system with a wide-ranging program
of banking-system restructuring.

Moreover, it is important to be aware that deposit insurance, even when
introduced at an appropriate time and in a well-designed form, cannot
address all stability issues. Deposit insurance is one element in the
financial safety net, which also includes a lender-of-last-resort
facility and good supervisory and regulatory practices. If introduced in
a coherent fashion, a deposit insurance system can be an important
pillar of the restructuring program. If introduced in isolation,
however, a deposit insurance system may not be effective.

### 

### Market-based *versus* state-directed financial intermediation

In undertaking a situational analysis of conditions in a country,
policymakers need to consider whether financial intermediation is
market-based or state-directed. When resource-distribution and credit
decisions are directed by the state, the state is viewed as being
responsible for the results of such operations. Deposits in such systems
generally are perceived as having full guarantees.

By contrast, financial systems characterised by market-based financial
intermediation often can benefit from deposit insurance because they do
not carry implicit government backing. A number of countries have
state-owned banks that operate in response to market signals. If these
deposits are not perceived as carrying a guarantee of the government,
these countries also may benefit from the establishment of a deposit
insurance system.

**Legal, regulatory, supervisory, accounting, and disclosure regimes**

It is important to assess the state of the legal, regulatory,
supervisory, accounting, and disclosure regimes. If these regimes are
strong, policymakers have a wider range of deposit insurance
alternatives from which to design an effective deposit insurance system.
Conversely, if these regimes are weak, fewer alternatives are available.
In such circumstances, an effective deposit insurance system may be
difficult to achieve.

*Legal regime*

It is important to assess the degree to which an appropriate legal
regime is in place when considering the introduction of, or enhancements
to, a deposit insurance system. A critical element of a sound legal
regime is the ability to enforce laws. If laws do not exist, or the
regime is characterised by inconsistencies, then it is very difficult
for a deposit insurance system to be effective.

A well-defined legal regime, including bankruptcy provisions and
certainty regarding property rights, contributes to the effectiveness of
a sound deposit insurance system. Also, it is important that employees
of the deposit insurer and other safety-net participants be provided
with legal protection from personal liability for the actions they take
on behalf of their organisations.

Deposit insurance systems with broad mandates will need other provisions
established by law. Factors that should be considered include the
ability of a legal regime to support early intervention and prompt
corrective action by supervisory and regulatory authorities, facilitate
prompt closure of problem institutions, and provide for the clear and
orderly liquidation of assets and the resolution of creditor claims. If
laws governing valuation methodologies, liquidation of assets, and the
resolution of creditors' claims are nonexistent or deficient, it will be
more difficult for the deposit insurer and other safety-net participants
to fulfil their mandates.

###### 

###### Regulatory and supervisory regimes

###### 

###### The quality of regulation and supervision will have implications for the type of deposit insurance system chosen. If a country has strong prudential regulation and supervision, and pertinent information is shared with the deposit insurer, an explicit deposit insurance system is more likely to be effective. There are many aspects to a good supervisory and regulatory system. Such a system should allow only viable institutions to operate. In many countries this is done by ensuring that institutions are well-capitalised and follow sound and prudent risk management, governance, and other sound business practices. Other characteristics include a sound licensing or chartering regime for depository institutions, and regular and thorough examinations or risk assessments of financial institutions. 

In addition, supervisory and deposit insurance authorities require
skilled and motivated staff, an adequate infrastructure, and access to
sufficient funding to assist them in fulfiling their mandates.
Authorities that are subject to an accountability regime, such as
regular performance reviews, can provide additional integrity to a
financial system.

#### *Accounting and disclosure regimes*

#### 

#### The effectiveness of a deposit insurance system is enhanced by accurate and reliable accounting and financial reporting systems. If information is readily available, accurate, and timely, it can be used by management, depositors, the marketplace, and regulatory and supervisory authorities. The better the information that is disclosed by institutions, the more effective is market discipline.

Attributes of a sound accounting system include accurate and meaningful
assessments of information in areas such as: asset valuation; the
measurement of credit exposures, loan-loss provisioning, and
nonperforming loans; the treatment of unrealised losses and
off-balance-sheet exposures; and capital adequacy, bank earnings and
profitability. Sound external auditing and reporting systems for
individual financial institutions help to foster market discipline. In
many countries this has been achieved through adherence to
sound-and-prudent accounting principles and practices, and methods to
ensure compliance with agreed-upon accounting conventions. In order to
be effective, accounting rules need to be applied consistently by all
interested parties.

The presence of a system to provide for good public disclosure of
financial information helps to ensure that accurate information on the
state of financial institutions is transmitted on a timely basis to all
interested parties. To be effective, a sound disclosure regime needs to
provide detailed information and frequent disclosure. In addition, many
countries hold directors, auditors, and senior management accountable,
in part, for the level, accuracy and consistency of disclosure. This can
enhance the exercise of market discipline over institutions and improve
the effectiveness of a deposit insurance system.

**Structure of the banking system**

The structure of the financial system is an important consideration when
adopting a deposit insurance system or enhancing existing deposit
insurance arrangements. For instance, the number, type and
characteristics of financial institutions have implications for the
design of a deposit insurance system.

Countries faced with a highly concentrated banking system have adopted
one of several approaches. First, some countries have opted not to offer
deposit insurance. In the absence of a deposit insurance system, it is
recognised that taxpayers likely will be called on to provide resources
to resolve any serious problems. Second, some countries have chosen to
rely on privately funded, mutual guarantees among the large depository
institutions in the financial system. Those depository institutions may
understand each other\'s business better than public authorities and can
be in a better position than public authorities to exert market
discipline on one another. Third, some countries have chosen to
establish a publicly managed and funded deposit insurance system. Such a
system may be chosen because the government provides backing to the
deposit insurer and to support public regulation and supervision of the
activities, including competitive practices, of a concentrated banking
system.

Countries that have banking systems characterised by a low degree of
concentration may be well-suited to a publicly managed deposit insurance
system. In this case, the exposure of the deposit insurer is likely to
be more diversified and the failure of one or a few banks may not
represent a major financial burden. As a result, the requisite resources
to protect depositors under such conditions are likely to be within the
capacity of a deposit insurance system to fund. However, the existence
of a large number of institutions may place greater burdens on the
supervisory authorities. Moreover, if individual institutions are not
diversified geographically, they may be more vulnerable to local
economic problems, and may thereby pose greater risks to the deposit
insurer.

The type and characteristics of financial institutions have implications
for deposit insurance. For instance, when countries undertake their
situational analysis, they may encounter the issue of foreign ownership.
Branches or subsidiaries of foreign banks may have the backing of the
home-country bank. It may be more appropriate, however, to treat the
branch or subsidiary as any other bank in the country's system as
regards deposit insurance. There are several reasons for this approach.
First, the home bank may fail. Second, some jurisdictions do not extend
deposit insurance to deposits in foreign branches or subsidiaries and do
not insure deposits of non-residents. Finally, many jurisdictions
require that the worldwide assets of a failed bank be frozen and used to
cover home deposits first. If deposit insurance is extended to branches
and subsidiaries of foreign banks, the deposit insurance authority will
need to consider how it will manage its risks.

**\
**

**Implementation Considerations**

Public attitudes and expectations regarding deposit protection are
important factors to be considered. The more aligned a deposit
protection system is with public attitudes and expectations, the more
likely it is that the system will be effective. For instance, if public
awareness of the benefits and limitations of new or existing deposit
protection systems is limited, then it may be more difficult for such
systems to achieve their public-policy objectives. Therefore, it is
important to undertake an analysis of public attitudes and awareness
before the introduction of a new system or major modifications are made
to an existing protection regime. If there are significant gaps between
expectations and planned systems or reforms, then they will need to be
addressed through public awareness programs.

**Conclusions**

Countries considering the introduction or modification of a deposit
insurance system should conduct a systematic situational analysis to
guide their deliberations. In conducting such an analysis, the economic
and institutional conditions and their effect on the options available
for a deposit insurance system must be considered. Country-specific,
historical factors and public sensitivity to the relevant issues also
must be taken into account.

[^1]: The Subgroup members are the International Monetary Fund
    (coordinator), Argentina, France, Mexico, and The World Bank.

[^2]: As described in the paper on public-policy objectives, there is a
    wide range of more specific formulations that fall into these
    categories.

[^3]: See papers on: membership, coverage, funding, reimbursing
    depositors, depositor priority and rights of set-off, structure and
    organisation, interrelationships, and powers.

[^4]: The Strategic Analysis Model was developed to assist policymakers
    in the design of an effective deposit insurance system. See the
    Financial Stability Forum Working Group on Deposit Insurance, *A
    Consultative Process and Background Paper*, June 2000.

[^5]: A distinction should be made in this analysis between the
    introduction of an explicit deposit insurance system and the
    introduction of blanket guarantees for all creditors, including
    depositors. Under conditions of extreme macroeconomic instability,
    when depositors are shifting out of the national currency and into a
    foreign currency held outside the banking system, a blanket
    guarantee, adopted in conjunction with a broad-based stabilisation
    plan, can strengthen confidence in the banking sector. However,
    there are substantial trade-offs in terms of increased moral hazard
    associated with blanket guarantees. See the paper on moral hazard.