**COVERAGE**

**Abstract**

To be effective, the scope of deposit insurance coverage and its level
must be set to meet the objectives of the deposit insurance system while
mitigating the deposit insurer\'s exposure to potential costs, including
those arising from moral hazard. Deciding what to cover and where to set
the level of coverage involves trade-offs. Coverage that is set at a low
level and with a narrow definition of what is covered, may not meet the
deposit insurer\'s objectives. In turn, coverage that is set at a high
level and that uses a broad definition of what is covered, may reduce
any potential incentive depositors have for monitoring bank risk-taking
and may increase the funding requirements for providing deposit
insurance. In addition, for a credible deposit insurance system to
exist, the public needs a well-defined and enforceable specification of
what is covered by deposit insurance. Coverage needs to be specified in
advance and should not be subject to interpretation after failures have
occurred.

**COVERAGE**

This paper represents the work of the Subgroup on Coverage Issues.[^1]
The scope of deposit insurance coverage and its level depend on a
country\'s willingness and ability to balance the achievement of the
deposit insurer\'s objectives with the introduction of incentives for
depositors to exercise some discipline. Deciding what to cover and where
to set the limits involves trade-offs between these objectives. Coverage
that is set too narrowly and levels that are set too low may fail to
prevent runs, while coverage that is set too broadly and levels that are
set too high may eliminate incentives for depositors to monitor
risk-taking.

The question of coverage is intertwined with issues that are covered in
various other papers.[^2] The scope and level of deposit insurance
coverage vary considerably across countries. This paper will explore
these variations and the considerations that go into selecting them. It
will identify issues, describe trade-offs, and make recommendations on
appropriate guidance for deposit insurance systems.

**Setting Coverage Limits**

Establishment of coverage limits should take into consideration the
scope and level of coverage needed to fulfil the public-policy
objectives of the system, as well as the potential costs that different
coverage limits may imply. Whatever scope and level of coverage is
selected, it must be credible and must be internally consistent with
other features of the deposit insurance system, including its funding
arrangements.

The potential costs of coverage take two forms. First, there is the
possibility that moral hazard may arise with high levels of coverage.
This will depend on practices that govern the financial sector in each
country. There are practices that can curtail the moral-hazard problem.
Countries that have adopted these practices may opt for high levels of
coverage without much cost.[^3]

The second potential cost is the additional funding requirement that
higher levels of coverage may bring. Since a higher coverage level does
not affect the recovery rate of assets, the deposit insurance system
will require a larger amount of funds when coverage is increased, other
things being equal. However, practices can be adopted to counteract the
need for more funding. In particular, the adoption of early-warning
systems and prompt corrective action can minimise the expected loss in
case of failure and counteract partially, or even totally, the increase
in funding needs.

The outcome of this process will be a combination of instruments to be
covered---the scope of coverage---and their coverage levels. This
combination will vary from country to country, depending upon the
objective(s) of the deposit insurer. For example, if the public-policy
objective is to protect small depositors, the type of financial
instruments held by these depositors should be determined. Such
instruments may include savings deposits, term deposits, demand
deposits, or other instruments. Availability, tradition, and tax
treatment likely will be factors that will determine the set of
instruments in each country.

Once the scope of instruments is determined, the level of coverage must
be set. To determine the level of coverage, data on the financial
instruments held by the population must be gathered. A useful set of
information are data that describe the relative importance of holdings
of different financial instruments in terms of both the number of
accounts and their size distribution. Such data will allow policymakers
to determine the fraction of the number of accounts and the fraction of
total deposits that will be covered under alternative coverage levels.
This could provide an objective measure of the appropriateness of a
given scope and level of coverage. Such information could be obtained
without imposing a heavy burden on individual insured institutions. For
example, a representative sample of deposit accounts across different
institutions can produce the necessary information at relatively low
cost.

Depositors often hold multiple accounts at a given depository
institution. Gathering data for depositors---which would, in effect,
aggregate multiple accounts for individual depositors---would require
additional effort. The necessary information, in principle, could be
obtained from the banks or through a survey of the population. Whether
such a survey is feasible and would produce accurate data may vary from
country to country. The gathering of such information could be repeated
every few years in order to track changes in the holdings of financial
instruments by the population.

Some commentators have suggested that the adequacy of a country\'s
coverage level should be judged by how closely it conforms to a uniform
measure across countries---such as the oft-cited level of twice per
capita gross domestic product (GDP). However, this approach fails to
consider that countries do not share the same characteristics with
respect to their financial systems or the same objective(s) for their
deposit insurance system.

The process for making choices regarding coverage limits is
country-specific. For example, a coverage level of twice per capita GDP
may prove adequate in a country that desires to provide deposit
insurance to small depositors. However, in a country with a similar
level of GDP, but a different income distribution, the same criteria
could product different results. Moreover, what is considered a \"small
depositor\" depends on the particular situation of a country and may not
be captured by a single parameter such as the level of GDP.
Additionally, objectives of the system may differ among countries.
Therefore, countries that are otherwise identical may end up with
different levels of coverage with respect to GDP if they have different
objectives for their systems.

**Exceptions to the Coverage Limit**

Once the scope and level of coverage are set, consideration can be given
to treating certain deposits and/or depositors as special cases. For
instance, many countries exclude from coverage the financial instruments
of depositors who are deemed capable of ascertaining the condition of an
insured institution and of exerting market discipline. Examples include
deposits held by other banks---interbank deposits---or other
professional investors, such as investment funds. Similarly, the
deposits of government departments and of regional, provincial, and
municipal governments and other public bodies also may be excluded. In
some cases, the deposits of individuals who are regarded as bearing
responsibility for the deterioration of an institution are excluded.
These may include deposits belonging to the directors, managers, large
shareholders, and auditors of banks.

In other countries, by contrast, the process of assessing the
public-policy objectives and the conditions within the country may lead
to the opposite conclusion with regard to the coverage of certain
instruments. For example, if the public-policy objective is to promote
stability in the payments system and if the distribution of banks is
such that there are a number of small banks that hold accounts in a few
large banks for clearing purposes, then it may be desirable to extend
coverage to include interbank deposits---possibly up to a limit.

Likewise, there may be cases in which the public-policy objectives imply
varying coverage limits according to the legal status of the depositor.
For example, some countries provide coverage only to natural persons
while in other countries coverage is extended to entities such as small
businesses. The later coverage may be justified because small
businesses, like small unsophisticated depositors, may not be able to
assess the risks of financial institutions. In such cases, a system
would have to be designed such that the personal funds of the
small-business owner are not co-mingled with the business-related funds.
In other cases, countries have opted to give separate coverage to
deposits held in trust and joint ownership.

In some countries, the public-policy objectives lead to the exclusion of
deposits that carry excessively high interest rates. These deposits may
be excluded in order to discourage weak institutions from being able to
bid away deposits from stronger, more prudently managed institutions. In
addition, countries that provide per-depositor coverage generally
exclude those deposits that are not registered to a particular
owner---bearer deposits---since there is no way of calculating the
coverage limit or proving eligibility when the depositor is unknown.
Some countries exclude deposits that are associated with
money-laundering activities.

**Application of the Coverage Limit**

After it is determined which financial instruments will be covered, and
for how much, the issue of how to apply the coverage limit must be
addressed. In general, there are three possibilities to consider. The
first is that the coverage limit may be applied per deposit, per member
institution. This limit easily could be circumvented by opening multiple
deposits of an amount equal to or below the maximum covered limit.[^4]
If a country wants to enforce a maximum coverage limit, then this
approach is not advisable.

The second possibility is to apply the coverage limit per depositor, per
institution. In this case, a depositor cannot increase his or her level
of coverage by opening multiple accounts in one institution. Information
requirements in this case are higher than in the previous case. If this
approach is chosen, there has to be a method for identifying deposit
holders. The additional costs to implement this requirement are likely
to be quite low, particularly in countries that require a standardised
identification form or a general-purpose ID number in order to open a
deposit account.[^5]

A third possibility is that in a country with multiple insured
institutions, the coverage limit may be applied per depositor across all
institutions. In this case, it is highly unlikely that the depositor
will be able to increase coverage beyond the stated limit, but the costs
of administering such a system could be high. This type of coverage
limit tends to be very difficult to administer as it requires not only a
great deal of information regarding ownership of the instruments in the
failed institutions, but also a process for determining when to combine
accounts at different institutions. To manage this system effectively, a
time element would have to be attached to the coverage limit---such as
per calendar year---and there would have to be a mechanism to track
depositor reimbursements to determine when a particular depositor had
reached the coverage limit. This option is seldom used because of the
high information and reporting requirements it entails.

**Coinsurance**

To foster market discipline and limit the costs of deposit insurance
associated with moral hazard, some countries have adopted a system of
coinsurance whereby depositors bear a pre-specified share of the
resultant loss from the failure of an insured institution.[^6] There are
drawbacks to such systems, however. One drawback is that it is possible
that small unsophisticated depositors would not monitor insured
institutions or exert sufficient market discipline because the costs of
doing so exceed the benefits. In this case, coinsurance would inflict a
cost on certain depositors without increasing market discipline. As a
result, these depositors may opt to stay out of the financial system. To
be effective, coinsurance requires that adequate information be provided
to the public regarding the condition of insured institutions than
otherwise might be the case. Such information, however, may not be
forthcoming.

One way to protect against some of the potentially adverse effects of
coinsurance is to apply coinsurance only above a certain amount. Under
such a system, small unsophisticated depositors would be protected
against the risk of loss. This, in turn, would presumably lower the risk
of runs. At the same time, such a system could maintain the incentive
for larger depositors to monitor insured institutions.

# **Adjusting Coverage Limits**

Over time, inflation can diminish the real value of deposit insurance.
In addition, changes in the composition and the size of deposits, and
the development of new financial instruments may make the current
coverage structure irrelevant. As the real value of deposit insurance
declines and the percentage of deposits covered by deposit insurance
decreases, it may become more difficult for the deposit insurer to carry
out its mandate. Periodic adjustments to the scope and level of coverage
may therefore be necessary. However, a trade-off exists between the
objective of maintaining the level of deposit insurance constant for a
sufficiently long period of time so that depositors can know the
coverage limit with certainty and the objective of preserving the real
value of deposit insurance coverage. This problem is especially acute
for high-inflation countries.

Adjustments to the scope and level of deposit insurance coverage may
take place either on an *ad hoc* basis or they may be made
systematically, such as through indexing. When adjustments are made on
an *ad hoc* basis, policymakers are in control of the process. This may
be viewed as either desirable or not, depending on the circumstances
within the country. Alternatively, indexation of coverage levels may be
viewed as a way to \"de-politicise\" the coverage question.

Indexed adjustments may be implemented automatically, which would
require care in choosing the frequency and amount of adjustments. If
adjustments occur too often or for odd amounts, this could lead to
confusion among the public as to the insurance limit. It also could be
expensive to implement such adjustments, as the public would have to be
informed about the new limits. On the other hand, if adjustments occur
too infrequently, this could produce large increases in uninsured
deposits and significant declines in the number and amount of deposits
insured over time.

A number of countries with histories of high inflation define coverage
limits in terms of indexing units to maintain the real value of their
deposit insurance coverage.[^7] This provides for automatic adjustment
of the coverage level for insured deposits without the need to change
the information available to public---coverage in terms of the indexing
units is constant.

Even within a system of indexing, the limit in real terms should be
reviewed periodically in order to confirm that the objectives set for
the deposit insurer are being met. Changes in the size of financial
markets, expansion of the access to financial markets among households,
and the growth of real income are likely to necessitate changes in the
real value of deposit insurance.

# **Foreign-Currency Deposits**

The decision of whether to cover deposits denominated in foreign
currencies depends basically on the public-policy objectives of the
deposit insurer and the country-specific circumstances. In particular,
the decision to cover these deposits and its ramifications depend
heavily on the country\'s usage of foreign currency---as represented by
the amount of deposits denominated in foreign currencies as a percentage
of the total amount of deposits in the country. When this ratio is high,
it would be of little value to institute a deposit insurance system
without covering these deposits. On the other hand, providing credible
coverage for deposits denominated in a foreign currency requires the
deposit insurer to be protected against foreign-currency risk.

When foreign-currency deposits are covered, two decisions have to be
made. The first is whether deposits will be repaid in the foreign or
local currency. At a minimum, a deposit insurance system that offers to
repay depositors in a foreign currency must have access to sufficient
foreign assets or other sources of foreign-currency funding to make this
commitment credible. Alternatively, a deposit insurer may repay
foreign-currency deposits in the local currency. Under this option, the
rules should be clear with respect to which exchange rate will be used
to calculate the repayment, in order for the public to understand the
risks that they may face. If, for example, the rate prevailing on the
date of failure is used to convert the foreign-currency deposit into the
local currency, then the risk of devaluation between the date of failure
and the date of repayment is bourne by the depositor. If the conversion
of the foreign-currency deposit into the local currency is not made
until the day of repayment, the risk of devaluation is bourne by the
deposit insurer.[^8]

The second decision is whether to express the coverage limit in the
local or a foreign currency. If the limit is expressed in local
currency, its devaluation effectively will diminish the limit for
foreign-currency deposits. If the limit is expressed in foreign
currency, devaluation does not affect the effective coverage level.
Whichever approach is chosen, country officials have to be aware that
changes in the exchange rate can introduce changes in the relative
coverage of local- and foreign-currency-denominated deposits. Also,
country officials should specify which exchange rate will be used to
make the conversions when necessary.

**Conclusions**

-   Setting the scope and level of coverage requires striking a balance
    between the public-policy objectives, the need to limit moral
    hazard, and funding requirements. As a result, coverage limits are
    country-specific.

-   Each country must assess its unique situation in setting coverage
    limits, considering: the public-policy objectives of the deposit
    insurance system, the state of its financial system, the
    distribution of deposits among depositors, and the nature and
    quality of the supervisory and regulatory system in its country.

-   The selected coverage level must be credible and must be internally
    consistent with other features of the deposit insurance system,
    including its funding arrangements.

-   Limits to coverage should be applied per depositor, per financial
    institution. This reduces the possibility that depositors will be
    able to circumvent the coverage limits without imposing excessive
    administrative costs on the deposit insurer.

-   The scope and level of coverage should be revised periodically.
    Adjustments should be made as necessary in light of changes in the
    financial sector.

-   A deposit insurance system must take a pro-active approach to
    determining what is and what is not insured and must communicate
    this effectively to insured institutions and the general public.

[^1]: The Subgroup on Coverage is comprised of representatives from
    Chile (coordinator), Germany, Hungary, Italy, the United States and
    the International Monetary Fund. Members of the Subgroup on Coverage
    contributed information on their deposit insurance systems for this
    paper. Comments received from the Working Group\'s consultative
    process also were considered in the drafting process.

[^2]: See the papers on public-policy objectives, moral hazard,
    situational analysis, transitioning, membership, funding, depositor
    priority, depositor reimbursement and cross-border issues for
    in-depth discussions of these issues.

[^3]: The practices to curtail moral hazard are discussed at length in
    the paper on moral hazard.

[^4]: The opening of multiple accounts in order to increase deposit
    insurance coverage is referred to as \"deposit stacking.\"

[^5]: There may be other variations on how the coverage limit is
    applied. For example, the coverage limit may be applied per
    depositor, but a depositor may be able to increase his or her
    coverage limit by holding deposits under different rights and
    capacities. See the paper on reimbursing depositors.

[^6]: See the paper on moral hazard for a description of the mechanisms
    that countries may use to limit the exposure of their deposit
    insurance system.

[^7]: Some countries have used indexing units as a means to protect
    contracting parties from the effects of inflation.

[^8]: To illustrate, suppose that a depositor has a
    foreign-currency-denominated deposit of \$10 and the local currency
    is the Peso. On the day of failure the exchange rate is 1 Peso =
    \$1. By the day of repayment, however, the exchange rate is 2 Pesos
    = \$1. If the deposit is valued at the prevailing exchange rate on
    the day of failure, then the depositor will receive 10 Pesos on the
    date of repayment, which can then be converted to \$5. If, however,
    the deposit is paid at the exchange rate prevailing on the date of
    repayment, then the depositor will receive 20 Pesos, which can be
    converted to \$10. Under the first scenario, the depositor bears the
    risk of a devaluation; under the second scenario, the deposit
    insurer bears that risk.