metadata: authors: 0: author: Talley, Samuel H.
1: author: Mas, Ignacio
docna: 0: docna: Deposit insurance in developing countries
docty: Policy Research Working Paper
subtopic: Public Sector Economics,Banks & Banking Reform,Deposit Insurance,Public Finance Decentralization and
            Poverty Reduction,Natural Disasters,Financial Sector Policy
teratopic: Law and Development,Finance and Financial Sector Development
abstracts: cdata!: About a dozen developing countries have
            deposit insurance systems and several others are considering
            establishing them.  These systems are typically created to
            prevent contagious bank runs, to provide a formal national
            mechanism for handling failing banks, and to protect small
            depositors from losses when banks fail.  Without a deposit
            insurance system, many developing nations in recent years
            have extended implicit deposit protection to depositors on a
            discretionary, ad hoc basis.  Deposit insurance systems have
            several advantages over these implicit protection schemes.
            Deposit insurance probably gives the banking system more
            protection against bank runs, provides more protection for
            small depositors, and provides a faster, smoother
            administrative process.  On the other hand, deposit
            insurance probably creates more moral hazard for depositors,
            thereby contributing to the erosion of market discipline and
            increased bank risk-taking.  Deposit insurance also tends to
            be a more expensive mechanism for protecting depositors
            because it offers less freedom of action to policymakers
            than an implicit scheme. Finally, developing countries often
            do not adequately fund their deposit insurance schemes.  As
            a result, the systems often lack credibility in the
            marketplace and bank supervisors may be unable to close
            insolvent banks because the insurer would be unable to pay
            off insured depositors.
repnme: repnme: Deposit insurance in developing countries
display_title: Deposit insurance in developing countries
listing_relative_url: /research/1990/11/700148/deposit-insurance-developing-countries
topicv3: Commercial Banking m1326069 1236,Deposit Insurance m1326722 322,Treasury m1327009 1045,Financial Sector Development m1327681 1920,Erosion m1503662 3202
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Law and Development,Finance and Financial Sector Development
no_of_pages: 120
model_extractions: # Table of Contents

|I. Introduction ......................... ,<br>1<br>Scope of Research ................................................ 6|
|---|
|II. Analysis and Evaluation of Deposit Insurance.<br>8|
|Nature of Implicit Deposit Protection Systems.<br>9|
|Nature of Deposit Insurance Systems .10|
|Comparison of the Two Systems .13|
|The Failure Resolution Process .15|
|Moral Hazard .17|
|Bank Runs .19|
|Small Depositor Protection .19|
|Treatment of Banks .20|
|Capacity to Absorb Losses .21|
|Summary and Conclusion .23|
|III. Major Features of Deposit Insurance Systems .25|
|Types of Institutions Covered .25|
|Public versus Private Systems .27|
|Compulsory versus Voluntary Systems .30|
|Single versus Multiple Funds .33|
|Amount of Insurance Coverage .34|
|Types of Deposits Covered .42|
|Financing Deposit Insurance .46|
|Premium Assessment Policy .50|
|Investment Policy .57|
|Admission to Insurance ........................................... 59|
|Terminating Insurance .60|
|Handling Bank Failures .61|
|Organizational Arrangements .67|
|Summary and Conclusions .70|

The authors wish to thank members of the Financial Policy and Systems Division, Country Economics Department for helpful comments.
# I. INTRODUCTION

During the 1980s, banking instability has<sup>emerged as a major problem in</sup> both developed and developing countries.<sup>In response, governmuents</sup> in many of these countries have taken strong actions to<sup>restore their banking systems to</sup> health and strengthen their prudential<sup>regulation.</sup> There are a variety of reasons why<sup>governments want to have a stable</sup> banking system. One reason is to avoid<sup>a breakdown in the nation's payments</sup> system, which in large part is administered<sup>by the banking system. Such a</sup> breakdown could seriously impair economic<sup>activity and, in extreme cases, could</sup> force a nation into some form of barter with<sup>all of the inefficiencies</sup> that such systems entail. A second reason is to increase<sup>the nation's savings rate by</sup> providing people with a safe financial asset (bank deposits) that they can hold. By increasing savings, a nation can have<sup>more investment and achieve a higher</sup> rate of economic growth. Third, maintaining<sup>a sound banking system promotes the</sup> development and growth of financial intermediation. It is generally acknowledged that financial intermediation tends to produce a more efficient allocation<sup>of</sup> credit and resources in a nation than if financial<sup>transactions</sup> are carried out directly between surplus and deficit units.<sup>Finally, for social welfare reasons,</sup> governments often want to protect small<sup>depositors from losses in bank failures</sup> that could wipe out a sizable portion of their<sup>life savings.</sup> In order to achieve banking stability, governments have developed a variety of institutional arrangements that tend to promote stability. High<sup>on the list</sup> are banking laws and regulations that set the ground rules for bank operations. An important objective of these laws<sup>and regulations is to constrain bank risk</sup> taking. This is accomplished by designating the types of activities<sup>in which</sup> banks can engage, the types of loans<sup>and investments that banks can make, and</sup> the amount of capital that banks<sup>must maintain. Banking laws and regulations</sup>
2 also are designed to prevent inaider dealings and fraud by bank management. In addition to establishing a legal framework for banking, governments have established systems for supervising and examining banks. These systems are designed to assure bank compliance with laws and regulations and to prevent banks from engaging in unsound banking practices. Finally, governments have authorized their Central Bank to lend to individual banks experiencing liquidity pressures. By acting as a lender of last resort, the Central Bank can shield illiquid banks from having to sell assets at depressed prices in a disorderly market. In doing so, the Central Bank can prevent bank liquidity problems from turning into insolvencies.

Despite past government efforts to promote banking stability, the banking systems of many developing countries have experienced serious distress during the past decade. Indeed, the distress in some of these countries appears to have reached levels that are unprecedented during the last 50 years. The causes of this distress are numerous. One major factor has been the severe macroeconomic shocks that most developing nations have sustained. In many of these countries, these exogenous shocks have been exacerbated by inappropriate domestic economic policies, particularly large budget deficits and excessive growth of money and credit. The resulting economic dislocations have had serious adverse effects on the profits of many domestic firms, thereby impairing their ability to service their bank debt. As a result, banks in some developing countries now have extremely high levels of nonperforming loans that sometimes exceed 50 percent of their loan portfolio and several times their capital and reserves.

Banks in many countries also have been harmed by various government policies that reduce bank profits. These policies include high reserve requirements on which little or no interest is paid, laws that force banks to
3 allocate a portion of their lending to firms and sectors of the economy that are unprofitable, and requirements that force the banks to maintain branch offices in areas of the country where banks would not choose to operate voluntarily. Finally, many banks in developing countries have been crippled by incompetent management or managers who have used the bank to further their own interests.

The distressed condition of banks in some developing countries has raised the possibility of widespread bank runs and the collapse of the banking system. In response to this prospect, more than 25 governments in the past decade have intervened to help distressed institutions. The following three cases give a taste of the extent of the distress that had to be confronted and the actions that the government felt compelled to take. X In the early 1980s, the financial system in Chile had widespread insolvencies. As a result, the government in 1981 intervened and liquidated eight insolvent institutions that, in aggregate, held 35 percent of the financial system's total assets. A little over a year later, the government intervened again, placing eight institutions with 45 percent of the system's assets under the management of the Central Bank, and extended financial support to all but one of the remaining commercial banks. As a result of these actions, the Central Bank's holdings of nonperforming commercial bank loans as late as 1988 amounted to nearly 19 percent of the nation's gross national product.

In Colombia, losses of the banking system in the mid 1980s amounted to 140 percent of the system's capital and reserves. As a result, the government was forced to intervene in six banks that held 24 percent of the banking system's total assets.

**1** World DeveloRment ReDort, 1989, pp. 70-72
4 In th. Philippines 161 smaller institutions holding 3.5 percent of total financial system assets were closed between 1981 and 1987. In addition, the Central Bank was forced to intervene in two large public banks and five private banks. The public banks were liquidated in 1986 and their troubled assets(equal to 30 percent of the banking system's asse.s) were transferred to a separate agency. The five private banks are still under Central Bank supervision. 2 It is important to note that governments that have closed insolvent banks have had to decide how the losses contained in these banks should be allocated, particularly whether depositors should absorb some of the losses. In most cases, governments have decided to shield depositors, especially in the case of the failure of government-owned banks and large private banks. The primary reason for protecting depositors appears to have been the fear of a loss of public confidence and widespread bank runs. 3 In addition to restructuring distressed banks, some developing countries have taken two other actions to restore stability to their banking systems. First, some countries have attempted to strengthen their banking laws and regulations and improve their bank supervision and examination systems. In several cases, these actions were carried out in connection with World Bank 2 While governments in some developing countries have responded to distress in their banking systems, governments in other developing countries have not. The principal reasons for this lack of response by some countries appear to be: serious budgetary constraints; an unwillingness to deal with the difficult equity decisions involved in allocating the losses of insolvent banka; a reluctance to acknowledge previous misdirected lending to various public enterprises and political supporters; and fear that government action might spark bank runs. In many cases, this lack of action allowed the situation to worsen over time, in part because managements of insolvent banks pursued high risk ventures in a desperate attempt to return to solvency.

> 3 In recent years, government authorities in Argentina, Chile, Colombia, Thailand and Turkey initially closed banks and allowed creditors to incur losses, but then felt compelled to extend assistance to prevent widespread bank runs. See World Devel Reort, 1989, p. 80.
5 sector adjustment loans or IMF Technical Assistance Programs. Second, several countries in recent years have established deposit insurance systems. These countries include Chile, Colombia, the Dominican Republic, Kenya, Nigeria, Trinidad and Tobago, and Yugoslavia. These systems appear to have been created to help restore public confidence in the banking system, provide the government with a formal mechanism for dealing with failing banks, and assure that small depositors would be protected in the event of bank failures. In addition to these newly created systems, several developing countries, including Argentina and Turkey, that already had deposit insurance revamped their systems in the light of experience. Moreover, several other developing countries that do not have deposit insurance systems are now in the process of creating such a system (Brazil) or are considering the desirability of establishing a system.

Rather than relying on some form of deposit protection to prevent bank runs, governments could rely entirely on the lender of last resort mechanism to handle bank runs once they are in progress. However, it appears that many developing countries are reluctant to abandon deposit protection and place complete faith in the lender of last resort mechanism to handle a crisis. One reason may be fear that bank runs will take the form of movements from deposits into cash, real assets or foreign exchange, rather than the transfer of deposits within the domestic banking system. In the former case, the runs could have serious adverse macroeconomic effects, including increased inflation from the movement into real assets or downward pressure on the nation's foreign exchange rate from the movement into foreign exchange. Even if the run takes the form of deposit transfers within the domestic banking system, developing countries may not be totally confident in the ability of the lender of last resort to hardle these runs effectively.
6 The recent burst of interest in deposit insurance by developing countries is increasingly causing the World Bank to come to grips with these schemes and their implications for the stability and growth of banking systems. At present, the Bank appears to have a favorable view of deposit insurance systems. Indetthe creation of such systems has formed a part of several adjustment programs. The International Monetary Fund also has advised a number of developing countries on the creation and operation of these systems. To date, however, there has been very little analytical work done on deposit insurance systems in developing countries at the Bank, the Fund, or elsewhere. Moreover, policy makers could benefit from a review of recent experience with deposit ins trarce systems in the developing countries.

# ScoRe of Research

This study has two basic purposes. The first is to analyze and evaluate the implications and desirability of creating deposit insurance systems in developing countries. In order to do this, it is first necessary to establish an analytical framework. In recent years, a vast literature on deposit insurance has been produced. Most of this work has been done in the United States in response to widespread bank and thrift failures and the massive insolvency of the Federal Savings and Loan Insurance Corporation (the insurer of deposits in thrift institutions). Without explicitly recognizing the fact, this vast literature has employed an analytical framework that compares a deposit insurance system against a system where the government extends no protection to depositors.* We believe that it would be inappropriate to use this analytical framework to

> ' The most likely reason that American researchers have adopted this analytical framework is that prior to the creation of the deposit insurance systems in the United States in the early 1930s, the government did not intervene to protect depositors.
analyze and evaluate deposit insurance in developing countries. The reason is that developing countries, 'r fact, typically do intervene to protect depositors in failing bank situations. Consequently, if an analysis and evaluation of deposit insurance is to be relevant and useful, it is necessary to compare these explicit deposit protection systems with the implicit deposit protection schemes that are now widely employed in countries without deposit insurance. As might be expected, the conclusions of this study regarding deposit insurance differ significantly from those that have emerged from the existing deposit insurance literature.

The second objective of this study is to identify the major features of deposit insurance systems, and then review the pros and cons of alternative ways of structuring each major feature. Some of the major features that will be analyzed include the types of financial institutions that should be eligible for deposit insurance; whether the deposit insurance system should be public or private; whether the system should be compulsory or voluntary; the amount of insurance coverage that should be offered depo--.tors; and how the deposit insurance system should be financed.

As part of this study, we have prepared a survey of deposit insurance systems throughout the world, with particular emphasis on those in the developing countries. Appendix A contains a discussion of the major fcatures and performance of a dozen deposit insurance systems in the developing world, as well as the system in Spain, which has recently served as a model for one or more developing countries. Appendix B contains a table of the major features of deposit insurance systems in both the developing and developed world. This table is designed to allow the reader to make a quick comparison of the major features of these systems. The survey updates and considerably expands an earlier survey
8 done at the International Monetary Fund by Ian McCarthy in 1979. More recently, Charles W. Colomiris has done a survey of pre-FDIC regional deposit insurance systems in the United States. 6 Also, within the context of broader surveys of financial regulation and supervision, R.M. Pecchioli and Richard Dale reviewed deposit insurance systems for O.E.C.D. countries and the Group of Thirry countries. 7

# II. ANALYSIS AND EVALUATION OF DEPOSIT INSURANCE

As indicated earlier, we believe that the most useful way to analyze and evaluate deposit insurance systems is to compare them with the implicit deposit protection schemes that typically are employed in developing countries without deposit insurance. In order to compare these two systems, it is necessary to specify the major features of implicit and explicit systems. It is important to emphasize that in actual practice implicit and explicit systems do not take the same form in every country. Consequently, it is necessary to generalize their basic features. We believe that these generalizations constitute a satisfactory basis for reaching conclusions regarding the pros and cons of the two systems. Of course, in evaluating the two systems in a given country, policymakers should identify the specific features of the two systems in that country, and then use these features to compare the systems.

3 Ian S. McCarthy, 'Deposit Insurance: Theory anid Practice", International Monetary Fund, Staff Papers, September 1980, pp. 578-600.

6 Charles W. Colomiris, 'Deposit Insurance: Lessons from the Record", Economic Perspective, Federal Reserve Bank of Chicago, May/June 1989, pp 10-30.

7 R.M. Pecchioli, Prudential SuRervision in Banking, 1987, pp. 133-48; and Richard Dale, The Regulation of International Banking, 1987, pp. 141-55.
9

# Nature of Implicit Deposit Protection SysteMs

In an implicit deposit protection system (IDPS), government protection of depositors is totally discretionary. The government offers such protection, not because it is obliged to do so by law. but because it believes that such action will achieve certain public policy goals, because it may feel at least partly responsible for the losses that must be absorbed, or because it may consider it to be cheaper in the long run to do so. Moreover, the determination of the amount and form of the protection is based on ad hoc decision making within the government. No preexisting rules and procedures guide the decision making process, although prior actions in similar circumstances may influence the outcome. Any protection offered depositors normally would be financed out of the government's current budget or through the Central Bank.

In an IDPS, the government can extend protection in three basic w-7ays. First, when an insolvent bank is closed, the government can make direct payments to depositors or arrange for the failed bank's deposits to be assumed by another bank. Second, the governmo.it could arrange and financially support the merger of a problem bank into another bank. This initiative would prevent the failure of the bank, thereby protecting all depositors. Finally, the government can prevent the failure by rehabilitating the bank. This rehabilitation could take the form of a direct equity capital injection into the bank. Alternatively, the government could acquire some or all of the failing bank's non-performing assets at book value. This transaction would be tantamount to an equity injection, and also would have the advantage of giving the bank a fresh start with a clean portfolio. With both types of rehabilitation, the government is likely to emerge as the dominant shareholder, thereby effectively nationalizing the bank.
10

# Nature of Degosit Insurance Svstems

A deposit insurance system (DIS) is created by the passage of a depoit insurance statute, which sets forth the rules and procedures for the operation of the system. In particular, the act would specify the types of financial institutions and deposits that would be eligible for insurance, whether membership in the system would be voluntary or compulsory, the maximum amount of deposits that would be insured, how the system would be funded, the devices the insurer could employ to resolve failing bank situations, and so forth.

The amount of protection th't a DIS extends depositors depends on the maximum insurance coverage specified in the statute and whether the insurer has authority to resolve failing bank situatiocas ir. ways that extend de facto protection to uninsured depositors. For purposes of this study, we will focus on three basic insurance coverage schemes. These three schemes cover quite well the range of deposit protection incorporated in DISs that already exist. The major features of these three schemes are presented in Table 1, and can be compared with the major features of an IDPS and a system where the government does not intervene in failing bank situations.
11 Table 1

|||Alternative<br>D|eDosit<br>Protection<br>Sche..s|||
|---|---|---|---|---|---|
|||Nature of Protec|tion<br>O)ffered|Nodaliti<br>of|Ooeration|
|SYPS of System|Prototwee|Small<br>Denositors|Large<br>Devositors|Liauidatfon|mnrger or<br>Rehabilitation|
|No Intervention<br>Implioit<br>System|U.S. before<br>1934<br>Thailand,<br>Malaysia|None<br>DiscretLonary|None<br>DLscretlonary|No<br>Possible|No<br>Likely|
|Deposit<br>Ynsurnce<br>System||||||
|LLltedCaverage|Austri-a,<br>France,<br>Germany|Cuar_ed|None|Yes|No|
|lOOZ Coverage|Argentina,<br>1946-71|Guaranteed|Guaranteed|Possible|likely|
|Dlscretionary<br>Coverage|U.S.,<br>Spain|Guaranteed|Discretienary|Possible|Likely|
12 The _lmlte;_ poverage scheme is designed primarily to protect small depositors when banks fail. Under this scheme, deposit accounts are insured up to a certain maximum amount. When a bank fails, the insur-3r is authorized to pay off insured depositors up to the maximum amount, or arrange for all of the failed bank's insured deposits to be transferred to another bank. With a limited coverage scheme, the insurer is not authorized to rehabilitate banks or arrange financially assisted mergers, because to do so would extend de facto protection to uninsuied depositors by preventing failures.

The 100 Dercent coverage scheme is at the other end of the protection continuum. Under this scheme, all deposit accounts are fully insured. The insurer can employ a broad range of devices to resolve failing bank situations, including insured deposit payoffs or transfers, financially assisted mergers, and rehabilitations. It should be noted that 100 percent deposit insurance systems have been widely discussed in public policy circles and in the deposit insurance literature, but in practice have rarely been implemented.

The discretionary coverage scheme lies between limited coverage and 100 percent insurance. In a discretionary coverage system, all deposit accounts are insured up to a certain amount (as with a limited coverage scheme). However, unlike a limited coverage system, the insurer is authorized under certain circumstances to extend de facto coverage .o uninsured depositors by using a purchase and assumption transaction to resolve a failure8, or by arranging a financially assisted merger or rehabilitation to prevent a failure. The special circumstances that would have to prevail before the insurer could extend de facto 8 In a purchase and assumption transaction, the insurer arranges for another bank to assume alU of a failing bank's deposits and acquire some or all of the failing bank's assets in return for a cash payment by the insurer. Such a transaction also could be used with 100 percent coverage or in an implicit system.
13 protection to uninsured depositors would be: (1) the banking system is threatened by a loss of public confidence that might result in widespread bank runs; and (2) the need to protect against bank runs outweighs the erosion of market discipline that extending de facto protection to uninsured depositors would entail. In sum, a discretionary coverage scheme would function like a limited coverage arrangement when the banking system is not threatened, but could be converted into a de facto 100 percent insurance system if a threat is sufficiently serious to justify an erosion of market discipline. It should be noted that, given the instability and banking concentration often found in banking systems in developing countries, a discretionary coverage system might be used frequently to protect uninsured depositors.

While deposit insurance systems can be financed in a variety of ways, by far the most common way is to create a deposit insurance fund and require insured banks to make periodic premium payments to the fund. The government often makes an initial equity capital contribution to the fund to give the DIS some degree of credibility at the beginning. In some DISs, the insurer has authority to borrow from the Central Bank or the Treasury in order to meet its obligations. Also, the government may be authorized to contribute additional equity if the fund's capital should be depleted by losses.

# Comparison of the Two Systems

The goals of IDPSs and DISs are essentially the same--to promote banking stability and the development of the banking system and to contribute to social justice by protecting small depositors from losses when banks fail. At the same time, there are some important differences in the features of IDPSs and DISs. These differences are presented in Table 2. The identification of these
14 differences is crucial because they serve as the basis for evaluating the relative effects and desirability of these two alternative deposit protection systems. In the evaluation process, we will focus on the following six areas: (1) the failure resolution process; (2) the problem of moral hazard; (3) the prevention of bank runs; (4) the protection of small depositors; (5) the treatment of banks; and (6) the capacity to absorb large losses.

Table 2 Maior Differences Between Implicit Deposit Protection Systems and DeRosit Insurance Systems

|Feature|Implicit Systems|Devosit Insurance Systems|
|---|---|---|
|Existence of rules<br>and procedures<br>governing deposit<br>protection|No|Yes|
|Obligation to protect<br>depositors|No legal obligation;<br>protection is at the<br>discretion of the<br>government.|<br>Legal obligation to<br>protect depositors up<br>to the insurance limit;<br>insurer may have<br>discretion to protect<br>uninsured depositors.|
|Amount of protection<br>extended to depositors|Can vary from no<br>protection to total<br>protection.|Can vary from limited<br>protection to total<br>protection.|
|Ex ante funding|None|Typically banks through<br>premium payments;<br>government may provide<br>initial capitalization<br>and possibly regular<br>payments.|
|Funding in event of<br>bank failure|Government|From fund; shortfalls<br>may be covered by<br>special assessments<br>levied<br>on banks or by<br>loans<br>or additional<br>capital<br>from government.|
15

# The Failure Resolution Process

In handling failing bank situations, IDPSs and DISs have certain similarities and dissimilarities. The two systems are alike in that both can employ the same failure resolution devices -- closing and liquidating failing banks, merging the banks ot rehabilitating the banks to prevent their failure. However, as will be discussed below, the two systems are different regarding the administrative process involved in resolving failures.

The administrative process for handling failing banks and protecting depositors should be fast and smooth and produce outcomes that are relatively consistent over time. Based on these criteria, a DIS should produce better results than an IDPS. A DIS should result in faster and smoother resolutions because it operates on the basis of established rules and procedures spelled out in the deposit insurance statute. Moreover, a DIS is prefunded, thereby eliminating the need to determine the funding source for protecting depositors.

In marked contrast, the process of handling failing banks and protecting depositors with an IDPS will not necessarily be fast and smooth, and outcomes are likely to be unpredictable and inconsistent over time. An IDPS does not operate on the basis of predetermined rules and procedures. Rather, the entire process is discretionary and ad hoc, with only previous actions in somewhat similar circumstances serving as a possible guide. Moreover, because an IDPS is not prefunded, the government will have to determine a source of funding. If the source is the government budget, action by both the executive and legislative branches would likely be required. This required action may be slow and constitute a serious problem in a banking crisis when public confidence is eroding at a fast pace. Finally, an IDPS is apt to be subject to considerable
16 political pressures, thereby making outcomes less predictable and consistent over time.

With an IDPS, however, the government has considerable degrees of freedom regarding the protection of depositors in failing bank situations. First, the government can control the amount of protection offered. At one extreme, the government could extend no protection at all. At the other extreme, the government could fully protect all depositors -- an action that is most likely to be taken in the case of a large, highly visible bank where widespread depositor losses might undermine public confidence in the entire banking system. The government also would have the discretion to protect all depositors up to a certain amount of deposits, thereby assuring that all small depositors are fully protected.

In an IDPS, the government also has discretion to determine the form and timinz of the protection offered depositors. For example, the government could pay off depositors of a failed bank in the form of either cash or government securities. Moreover, the total payment to depositors could be made very shortly after a bank failure, or could be in the form of installments stretched out over a considerable period, thereby lowering the present value of the total payment. In contrast to an IDPS, the rules that govern a DIS tend to constrain in some degree the deposit protection options available to the insurer. For example, since the insurer is legally obligated to protect insured depositors, the insurer does not have the option of walking away from protecting these depositors in individual cases, as can be done by the government with an IDPS. Likewise, with a DIS the insurer typically is required to pay off depositors in cash (rather than using some other types of assets), and the insurer cannot
17 stretch out payments over time<sup>in order to reduce the present value of these</sup> payments.

In sum, the various constraints<sup>contained in the law governing a DIS can</sup> rule oat cheaper options, thereby<sup>making a DIS a more expensive deposit</sup> protection device than an IDPS. On<sup>the other hand, in some cases the rules under</sup> which a DIS operates may give<sup>the insurer greater protection from political</sup> pressure to bail out all depositors<sup>than the government</sup> would have under an IDPS. If so, a DIS could turn out<sup>to be a cheaper device.</sup> Moral Hazard The problem of moral hazard arises<sup>from the distortion in incentives</sup> induced by deposit protection,<sup>whether implicit or explicit. The presence of</sup> protection affects the behavior<sup>of the economic agents involved, particularly</sup> their willingness to assume greater<sup>risk. Both bankers and depositors may be</sup> subject to moral hazard.

If deposit protection is achieved<sup>by bailing out banks and their</sup> shareholders, shareholders may be subject to moral hazard by their<sup>ability to</sup> bet oa the government's or the insurer's<sup>money. In this case, banks can earn</sup> higher returns without facing the<sup>potential losses associated with higher risk</sup> strategies. However, it must be recognized<sup>that this danger can be present even</sup> without deposit protection because<sup>the existence</sup> of limited liability introduces an asymmetry in the risk/return<sup>trade off.</sup> Furthermore, if the deposit protection is structured so that shareholders and managers do not benefit from deposit protection, the introduction of this protection need not increase<sup>the</sup> moral hazard of bankers.

Depositors also experience moral hazard<sup>in that they no longer assume the</sup> risk associated with their choice<sup>of depository institution. If the investment</sup>
18 decision is made without regard to the financial condition of the institution, the market fails to exert a disciplining effect on banks.

The issue of moral hazard has received a great deal of attention in the deposit insurance literature. While deposit insurance clearly involves moral hazard, the central role given to moral hazard is often overstated. In evaluating the moral hazard asseciated with deposit insurance, the basis of comparison should be a world with implicit protection and limited liability, both of which already introduce a significant degree of moral hazard. Thus, the relevant measure should be the incremental amount of moral hazard introduced by switching to an explicit deposit protection system, rather than focusing only on the absolute amount of moral hazard associated with a DIS.

Returning to the comparison of DISs and IDPSs, the degree of moral hazard induced by each type of scheme will depend directly on (i) whether protection is extended to bank management and shareholders, and (ii) the feeling of safety imparted to depositors. Because explicit systems operate through a set of established rules, they can (and should) completely eliminate the expectation of managers and shareholders that they will benefit from DIS actions. Because such options are not ruled out in IDPSs, these systems are likely to result in greater moral hazard on the part of bankers.

As to the feeling of safety enjoyed by depositors, this will depend on (i) the level of coverage offered, and (ii) the public's confidence in the protection system. In our view, a DIS is likely to involve somew'hat more moral hazard on the part of depositors than an equally credible IDPS. The reason is that a DIS tends to extend more assured deposit protection. 9 With a DIS, some depositors 9 A priori, it is not clear whether a DIS or an IDPS would have more credibility.
19 are given full protection and all depositors have at least some protection. By contrast, with an IDPS, no depositors are guaranteed protection. In the case of a DIS with a high coverage level, the system could involve considerably more moral hazard than an equally credible IDPS.

In conclusion, it is not possible to establish categorically how the conversion from an implicit protection scheme to an explicit scheme would affect the overall amount of moral hazard in the banking system. In general, however, it seems likely that the conversion would result in less moral hazard on the part of the bankers, but more moral hazard on the part of the depositors.

# Bank Runs

The ability of deposit protection systems to stem bank runs depends on the extent that depositors feel protected from loss in the event of a bank failure. As indicated above, a DIS is likely to extend somewhat more assured deposit protection than an IDPS. Consequently, it follows that a DIS is likely to be somewhat more effective than an IDPS in preventing bank runs. Moreover, the difference in the effectiveness of the two systems would tend to be greater the higher the coverage of the explicit system.

# Small Depositor Protection

One of the traditional objectives of deposit protection systems is to protect small depositors. Both IDPSs and DISs are potentially capable of protecting small depositors. However, DISs appear to be better designed to accomplish this objective because the protection of small depositors is in the form of a legal obligation, and this legal obligation is backed up by a deposit insurance fund. By contrast, IDPSs involve no legal obligations to protect even small depositors.
20

# Treatment of Banks

One of the more important differences between an IDPS and a DIS is the treatment of banks. An IDPS confers a subsidy on banks that increases their profits. By contrast, a DIS either could confer a subsidy on banks or impose a tax.

By extending some form of protection to depositors, an IDPS lowers the risk of deposits. This reduction in risk should result in portfolio adjustments by wealth holders that would lower the interest rate on deposits. This reduction in banks' cost of funds should increase bank profits.10 With an IDPS, the losses incurred from protecting depositors are absorbed entirely by the government (taxpayers) or the Central Bank. Consequently, since banks derive benefits from an IDPS, but shoulder none of the costs, an IDPS confers a subsidy on banks.<sup>11</sup> By contrast, the effect of a DIS on banks is unclear. On the one hand, by protecting depositors, a DIS lowers banks' cost of funds. On the other hand, the costs of protecting depositors, while initially absorbed by the insurer, are uitimately passed on to banks in the form of premium payments.

10 Depending on competitive conditions in the banking industry, banks may pass on at least some of these profits to their customers in the form of more favorable prices on banking services.

11 This conclusion assumes that the government does not make an effort to offset this subsidy in some way--for example, by imposing some form of tax or regulatory requirement on banks that would have the effect of lowering bank profits.
21 Capacity to Absorb Losses One of the key features of a deposit protection system is the ability to absorb losses when banks fail. If a system lacks the resources to absorb losses, bank supervisors may be forced to allow insolvent banks to continue to operate. Experience has shown that the failure to close insolvent banks is apt to compound the problem of banking instability because insolvent banks have an incentive to take high risks in an attempt to return to solvency.

With an IDPS, losses are absorbed either by the national government budget or the Central Bank. Both of these constitute potentially large funding sources, far exceeding the resources of even a well financed DIS. However, national government budgets typically have strong contending demands, and governments may be reluctant to use Central Bank resources because of the inflationary implications. Therefore, the actual capacity of an IDPS to absorb losses may be significantly less than its considerable potential.

With most TISs, losses are absorbed by an insurance fund set up for that purpose. The ab. ity of a DIS to meet its obligations depends primarily on the fund's initial capitalization, the amount of premiums paid into the fund by insured banks over time, the size of the payments made to resolve failing bank situations, and the ability of the fund to borrow or receive additional capital injections when its resources are exhausted.

It is certairly possible for nations to establish financially sound DISs that are capable of dealing effectively with sizable losses. However, the historical record indicates that developing countries typically do not create such systems. Rather, they tend to set up DISs that have relatively little capital and do not have strong government back up support that DISs may need to get through a difficult period. As a result, the systems lack credibility and
22 are frequently frozen into inaction. The following case illustrates these problems.

Between 1984 and 1988, the DIS in the Philippines had to deal with **_ckh_** failure of approximately 140 banks representing 6 percent of total deposits of the banking system. Because the fund did not have sufficient resources, the insurer had to borrow extensively in order to meet its obligations. In addition, the insurer raised bank assessments, which had the effect of reducing the profits of an already troubled banking system. There is also reason to believe that the insurer, in order to be able to report a positive net worth, did not make adequate provisions for losses incurred in the liquidations.

There is evidence that several of the DISs recently created in developing countries have not been given sound financial structures. For example, when the government of Kenya set up a DIS in 1985, it provided the system with no initial capital. Likewise, when the Nigerian government set up a DIS in 1988, it provided the system with initial capital equal to only about one thousandth of the total assets of the banking system, even though it was known that the banking system contained several insolvent banks. In both Kenya and Nigeria, it will take substantial time for the DIS to build up sufficient resources to be able to handle any significant number of insolvent banks.

There is also much to learn about DISs from the recent deposit insurance crisis involving the Federal Savings and Loan Insurance Corporation in the United States. In the mid 1980s, this insurer of savings and loan associations suffered large losses that depleted the fund. While the insurer had limited authority to borrow from the United States Treasury, this authority was minuscule relative to the resources needed to handle remaining insolvent institutions. Since it was obvious that the insurer could not perform if additional insolvent thrifts
23 were closed, the supervisor of these institutions allowed these institutions to continue in operation. The management of some of these institutions, recognizing that they would not be closed, proceedud to acquire very high yield/high risk assets in a desperate attempt to return to solvency. As it turned out, many of the bets that these managements placed did not pay off. As a result, by the time that the United States government finally worked out a plan to resolve the deposit insurance crisis, the aggregate losses of insolvent thrifts had ballooned to well over $100 billion.

# Summary and Conclusion

In this section, we have analyzed and evaluated DISs relative to IDPSs, which are used in most developing countries that do not have deposit insurance. We argued that a DIS has both advantages and disadvantages compared to an IDPS. First, a DIS constitutes a better administrative process for resolving failing bank situations and protecting depositors. It tends to be faster, smoother and more predictable that an IDPS, and it tends to produce more consistent results over time. The reason is that a DIS operates on the basis of predetermined "rules of the game", whereas decision-making with an IDPS is discretionary and ad hoc. On the other hand, the inherent flexibility contained in an IDPS gives policymakers more degrees of freedom in fashioning deposit protection remedies. Consequently, policymakers should have more control over the amount, form and timing of the protection offered. Second, a DIS is more effective in protecting small depositors because it is, in part, designed to accomplish this result. By contrast, small depositors may not be protected in some cases with an IDPS, particularly in the case of the failure of a small bank. Third, a DIS provides a vehicle for shifting some of the costs of deposit protection to the banking system. This seems appropriate because banks derive benefits from deposit
24 protection in the form of a lower cost of funds. By ccntrast, with an IDPS banks derive the benefits of deposit protection, but incur none of the costs. As a result, an IDPS subsidizes banks at the expense of taxpayers.

It is widely argued in the deposit insurance literature that the primary problem with deposit insurance is moral hazard. We do not share this view. While there is no question that deposit insurance involves moral hazard, it is not clear that it involves any more moral hazard than an IDPS, which most countries use in the absenice of a formal DIS. It is not the absolute amount of moral hazard that is important, but rather the relative amount.

Instead, we believe that the major problem with DISs, particularly in developing countries, is that they tend to be given weak financial structures. This is an especially serious problem in developing countries because tney tend to have unstable banking systems that are likely to produce large losses. Given this situation, we believe that the World Bank should adopt a wgo sloww policy regarding the creation of DISs in developing countries. DISs should be considered only in those countries that: (i) have at least a fairly stable banking system; (ii) have an effective prudential regulation and bank supervision system; and (iii) exhibit a willingness to adequately fund a DIS and give it the necessary government back up support that may be required to get the system through a period of stress. In our judgment, there probably are relatively few developing countries that now meet these conditions.

For those countries that do not meet these conditions, the emphasis should be placed on trying to get the banking system under control. In many countries, this would require stabilizing the macroeconomic environment in which banks and business firms have to operate, strengthening the nation's banking laws and bank
25 supervisory and examination systems, and continuing to rely on an IDPS to protect depositors and restructure banks.

# III. MAJOR FEATURES OF DEPOSIT INSURANCE SYSTEM

While deposit L$surance is a relatively simple concept, deposit insurance systems are relatively complex mechanisms. In setting up a deposit insurance system, nations have to make a sizable number of decisions regarding the system's major features. The objective of this section is to identify the major features, review the pros and cons of the alternative ways that each feature could be structured, and offer recommendations regarding the preferred options.

# TyRes of Institutions Covered

In some developing countries, only commercial banks are eligible for deposit insurance. In most developing countries, however, the DIS includes at least some non-commercial bank depository institutions, such as savings and loan associations, savings banks, merchant banks, credit unions, and development banks.

The type of institutions that ought to be included in a DIS depends on the purpose of the system in individual countries. If the primary purpose is to protect the payments mechanism, the system logically could be confined to commercial banks and any other depository institutions that issue transaction accounts. However, most nations view a DIS as having broader purposes than just protecting the payments system, including protecting small depositors, promoting savings in the economy and fostering the development of the financial intermediation process. For nations having these broader objectives, it would
26 seem appropriate to include in the DIS all types of institutions that are authorized to issue deposits to the public.<sup>12</sup> There are two other reasons for including all types of depository institutions in the system. First, if some depository institutions are not insured and they begin to experience runs, these runs may spill over on to insured institutions. The reason is that during a panic depositors may not carefully distinguish between insured and uninsured institutions. Second, differential access to deposit insurance could confer advantages on various types of competing depository institutions, thereby introducing distortions within the financial sector.

**12** I is also possible for a country to restrict deposit insurance to one or several types of depository institutions in order to promote their development relative to other institutions. For example, in Paraguay deposit protection was restricted to a narrow set of newly established, deposit-issuing mortgage banks in order to promote mortgage lending.
27

# Public Versus Private _Systems_

Existing DISs take a variety of forms<sup>with regards to their sponsorship,</sup> administration and financing, and cover a broad range<sup>from pure public systems</sup> to pure private systems. At one end<sup>of the continuum (we will arbitrarily call</sup> it the "left") are unconditional government guarantee systems that are entirely managed and funded by the national<sup>government. The present system in Yugoslavia</sup> and the earlier systems in Chile<sup>(up to 1986) and Argentina (up to 1979) fall</sup> into this category. At the left<sup>of center are government-run</sup> schemes that are administered by a separate deposit insurance corporation that is funded at least partially by the insured banks. The amount of independence that<sup>these</sup> corporations have, particularly with regards to the Central Bank,<sup>varies from</sup> country to country. In the present<sup>deposit insurance system in Argentina and</sup> the earlier systems in Spain (up to<sup>1980) and Turkey (up to 1983) the insurer</sup> is, or was, intricately connected with<sup>the Central Bank. By contrast, in the</sup> present schemes in India, Kenya,<sup>Nigeria, the Philippines, and Turkey (after</sup> 1983), the insurer enjoys a greater<sup>degree of independence. At the center of</sup> the continuum are government-sponsored deposit insurance corporations that are managed by representatives drawn from both the government and the<sup>banks. Bank</sup> representatives are in the minority in Cuba and Colombia,<sup>but in Spain (after</sup> 1980), banks have equal representation with the government. These jointly administered insurers are at least partially funded by<sup>the banks. Leaning toward</sup> the right are schemes that are mandated<sup>or encouraged by the government,</sup> but are owned, managed and financed by the banks.<sup>The system now being developed in</sup> Brazil fits into this category, as do the<sup>existing systems in France and Germany.</sup> At the extreme right are systems<sup>(as in Switzerland) that merely involve</sup> voluntary private agreewonts among<sup>banks to insure each others' deposits. The</sup>
28 government plays no role in sponsoring and administering such systems and provides no financing.

There seems to be a tendency for more recently established DISs to rely less on government financing and management than earlier schemes. In fact, all countries that have recently reformed their DISs have moved further to the right on the continuum. For example, Spain's DIS was made independent of the government in 1980, Argentina and Chile moved from sole reliance on government funding to a system that is at least partially funded by banks, and bank funding for Turkey's DIS was increased after 1983. The reason for this movement to the right, especially regarding funding, may be that governments have become increasingly unwilling to. accept the full burden of potentially unlimited losses. In general, developing countries rely to a greater extent on government participation in deposit insurance systems than is the case in developed countries. There are several factors that may account for this tendency: (1) banks in developed countries have the financial strength to absorb the additional cost of deposit insurance assessments and to face potentially high contingent liabilities, whereas thase factors could constitute an excessive burden for banks in developing countries; (2) because banking systems in developing countries are small, banking activity is very interconnected and hence mutual insurance would be unworkable; (3) bank ownership in developing countries is tilted more toward the government, and it is only reasonable for the government to be directly involved in the insurance of its own banks; and (4) private management of a DIS would tend to drain the already very limited managerial resources of private banks in many developing countries.
29 The appropriate public sector-private sector mix for a DIS could vary significantly from country to country, depending on the unique characteristics and capabilities of these countries. In general, however, DISs in developing countries are far more likely to achieve their objective of preserving public confidence, promoting the development of the financial sector, and protecting small deposits if they employ either a public system or a quasi-public system (a system that is jointly managed by government and banking officials, but has some form of government financial backing). Private systems that rely solely on the banking industry for financial support typically should be avoided because they are apt to break down during a banking crisis.

Losses incurred by a deposit insurance system are highly unpredictable and are likely to be large during a period of adversity. These large losses may well exceed the resources of the insurance fund, in which case a capital injection by the sponsors would be needed. A national government, which stands behind a public or quasi-public system, generally would have much greater capacity to provide capital than would the banking industry, which stands behind a private system. During a banking crisis, some banks are likely to suffer an erosion of capital. The need to transfer some of their remaining capital to the deposit insurance fund would further weaken their position. On the other hand, a refusal by some banks to provide capital might result in the insurer being unable to meet its obligations. This inability could produce a loss of confidence in the deposit insurance system and precipitate widespread runs on the banks. In sum, a private system where the banking industry, in effect, insures its own losses is inherently vulnerable and is unlikely to be successful over the long run.

A possible alternative way to design a private deposit insurance system is to have nonbanking organizations provide the insurance. The most likely
30 provider would be the insurance industry. However, there are a number of reasons for doubting that such an arrangement would be feasible. First, in most developing countries the banking industry is far larger than the insurance industry. As a result, the insurance industry would not have the capacity to underwrite deposit insurance. Second, even if the insurance industry had the capacity, it is not clear that they would want to underwrite deposit insurance because of the risk--bank failures do not tend to be independent events. Third, insurance companies probably would be unwilling to insure deposits unless they could close insolvent banks--authority that the government almost surely would be unwilling to grant."3 Finally, insurance companies almost surely would want the power to cancel the insurance of individual banks. The act of cancelling insurance, however, is likely to precipitate a large scale run on the bank involved and lead to its failure. It is doubtful that the government would be willing to give a private insurer that degree of control over the fate of individual banks.

# Compulsory versus Voluntarv Systems

DISs can be either compulsory or voluntary. In most developing countries (and a majority of developed countries), banks are required to join the system. The only truly voluntary system in the developing world at present is the one in Argentina. The system now being developed in Brazil will be a mixed compulsory/voluntary system--universal banks will be required to join the system while all other institutions will have the option of joining. In general, voluntary systems tend to be either private systems (as in France, Germany, and

> " Closing banks is a long-standing responsibility of the government. Moreover, to avoid losses, the insurer would have an incentive to close banks before they become insolvent.
31 Switzerland) or systems where the funding has been switched<sup>from sole reliance</sup> on the government to funding by insured<sup>banks (as in Argentina). In the latter</sup> case, the system was presumably placed<sup>on a voluntary basis to make the switch</sup> in funding more palatable. The DIS<sup>in Spain is technically</sup> a voluntary system, but there is a strong incentive for banks to<sup>join the system because membership</sup> is a prerequisite for receiving any kind<sup>of financing from the Central Bank.</sup> The major arguments in favor of a voluntary<sup>system are essentially</sup> philosophical and political in nature. Requiring banks to be<sup>insured involves</sup> a greater degree of government intervention in the financial system than merely providing insurance to ba.-cs on a voluntary basis. Also, in some countries where banks are owned by lower levels of government, it may be<sup>politically awkward for</sup> a national government to compel these banks<sup>to join the deposit insurance system.</sup> With a voluntary system, potential inter-governmental conflicts regarding membership in the system are avoided.

The major disadvantage of a volunzary system is that it could<sup>exacerbate</sup> banking instability. The reason is that a voluntary<sup>system is likely to produce</sup> a two-tiered banking system--one part protected<sup>and the other unprotected.</sup> During tranquil times, some depositors (presumably<sup>larger, more sophisticated</sup> depositors) are likely to prefer holding<sup>their deposits at unprotected</sup> banks in order to obtain the higher deposit<sup>rates that these banks would offer to</sup> compensate depositors for the greater risk.<sup>During a crisis, however, the</sup> risk/return preference of these depositors<sup>is likely to shift dramatically</sup> and result in their transferring deposits from unprotected to protected banks. These deposit shifts could be large and could put a<sup>considerable</sup> strain on the lender of last resort. If the lender of last resort<sup>could not handle the liquidity</sup> crisis, unprotected banks could be forced to<sup>sell large amounts of assets in a</sup>
32 disorderly market at If ire sale" prices. The resulting erosion of equity capital could produce numerous insolvencies. In sum, a voluntary system is likely to be inherently unstable, producing large scale deposit shifts between protected and unprotected banks, depending on the state of public confidence in the banking system. Protected banks would ride the .ablic confidence cycle anticyclically while unprotected banks would ride it procyclically.

A voluntary system also could produce problems because its membership may be unstable. For example, well regarded banks might choose to withdraw from the system if bank failures rose sharply and large special premium assessments were levied in order to replenish the insurance fund. These withdrawals from the system would tend to throw an even greater financial burden on those less well regarded banks that felt that they could not survive outside the insurance system.

There are several other less serious problems with a voluntary DIS. First, a voluntary system is unlikely to extend protection to all small depositors because at least some banks may stay out of the system. If so, one of the major objectives of a DIS, to protect small depositors, would not be achieved. Second, in initially designing a voluntary DIS and changing some of the features of such a system over time, policy makers would always have to consider the effects of their decisions on membership and the resulting robustness of the DIS. This factor could act as a constraint and force policy makers into trade-offs that could result in a less well designed system. By contrast, a compulsory system introduces no such constraints into the decision making process.

While there appears to be a strong case for having a compulsory DIS, some would argue that in a mixed banking system, government-owned banks should not be compelled to join a DIS. One reason is that government-owned banks do not
33 need insurance to protect depositors because the government will not allow these banks to fail. Another reason is that the insurer, if owned by the government, in some instances might give government-owned banks better treatment than private banks.

The counterargument is that in a mixed banking system public and private banks must be given parallel treatment in order to maintain competitive equality. Consequently, if private banks are compelled to join the DIS, public banks also should be required to join. If this is not done, both types of banks would end up with some form of deposit protection (private banks through deposit insurance and public banks through likely government bailouts), but only private banks would have to pay for the protection (through insurance premiums).

It is possible that if government-owned banks are included in the DIS, they might receive preferential treatment by a government-owned insurer. However, this argument is weakened by the fact that the government, if it wanted, could favor public banks over. private banks through other channels--for example, through more lenient supervisory treatment, favored tax treatment, lower reserve requirements, and so forth.

# Single versus Hultiple Funds

In most countries that have a DIS, one fund is used for all types of institutions included in the insurance program. However, in Germany and the United States different funds are used to insure different types of institutions. In the case of Germany, separate funds exist for commercial and mortgage banks on the one hand, and savings banks and regional giro institutions on the other. In the United States, three different funds are employed for, respectively, commercial banks, savings institutions and credit unions.
34 One argument for setting up separate funds is that different types of institutions may have different risk profiles. Consequently, in order to avoid having relatively low risk institutions cross-subsidizing relatively high risk institutions, it is necessary to set up separate funds for each class of institution. However, setting up multiple funds goes against the grain of insurance, which is premised on the concept of risk diversification. Indeed, a scheme devoted exclusively to institutions that are exposed to the same types of risks is particularly susceptible to exogenous shocks. Thus, the fragmentation of DISs is to be avoided.

The problem of potential cross-subsidization in a single fund could be handled in either of two ways: (i) by charging differential insurance premiums based on an institution's overall risk profile; or (ii) by implementing differential capital requirements that bring the overall risk profile of different institutions into balance.

# Amount of Insurance Coverage

The amount of insurance protection extended to individual depositors is an important feature of a DIS. Indeed, it probably has more to do with the basic character and the ultimate effects of the system than any other feature. As discussed earlier, insurance protection can take the form of de jure protection -- the amount of protection that the insurer is legally obligated to extend to depositors in the event of a bank failure -- and de facto protection -- the protection that the insurer effectively extends to uninsured depositors by resolving a failure in a way that protects all depositors from losses.

As shown in Table 3, the maximum amount of de jure protection offered depositors varies widely from country to country. Yugoslavia and Norway currently grant unlimited protection -- that is, they employ a 100 percent
35 insurance system. For those countries that set a ceiling, the ceiling is generally much higher for developed countries than for developing countries, reflecting in part the higher average deposit balances in the developed countries.

In several countries there are certain caveats that apply to the stated amount of insurance protection that expand or contract actual coverage. In Argentina (after 1979) and in Chile (under that country's complementary scheme where depositors voluntarily could purchase insurance above the limit), deposits are partially covered above the ceiling--90 percent in Argentina and 75 percent in Chile. In other systems, including Argentina's and the proposed system in Brazil, the ceiling is indexed so that coverage will increase with inflation. In most other countries, the ceiling is modified from time to time to reflect changes in the price level, the financial status of the insurance fund, and/or the country's policy goals. In Belgium, the amount of coverage can be reduced if the insurance fund is not large enough to satisfy all claims. Finally, the United Kingdom has employed the concept of co-insurance by insuring only 75 percent of the deposit balance. With this system, therefore, there is always some risk sharing between depositors and the insurer, thereby instilling a considerable degree of market discipline into the banking system.

In a majority of DISs in the developing countries, the insurer has authority to prevent a failure by rehabilitating a troubled bank or arranging for a financially assisted merger. This authority gives insurers in these countries the power to extend de facto protection to uninsured depositors, at least under certain circumstances.
36 Table 3

# Maximum Coverage Rer DORositOr

|Country|Year|Local Currency<br>Value|US$ Value|1988<br>US$ Value|
|---|---|---|---|---|
|Argentina|1988|A<br>81,000|8,416|<br>8,416|
|Austria|1986|AS<br>200,000|13,100|<br>14,116|
|Belgium|1985|BF<br>500,000|8,421|<br>9,248|
|Brazil|1988|OTN<br>3,500|16,500|<br>17,780|
|Canada|1986|C$ 60,000|43,181|<br>46,530|
|Chile|1977|t.u.<br>100|1,000|<br>1,949|
|Chile (comp.)|1981|t.u.<br>250|5,061|<br>6,576|
|Colombia|1988|Col$ 200,000|668|<br>668|
|France|1985|FF<br>400,000|44,518|<br>63,829|
|India|1980|Rs.<br>30,000|3,815|<br>5,470|
|Japan|1986|Y 10,000,000|59,340|<br>63,942|
|Kenya|1985|Kshs. 100,000|6,086|<br>6,684|
|Netherlands|1986|Fi<br>35,000|14,286|<br>15,394|
|Nigeria|1988|N<br>50,000|10,860|<br>10,860|
|Norway||unlimited|u|nlimited|
|Philippines|1988|P<br>40,000|1,896|<br>1,896|
|Spain|1981|ptasl,500,000|16,248|<br>21,111|
|Switzerland|1984|SF<br>30,000|12,768|<br>14,521|
|Turkey|1983|TL 3,000,000|13,306|<br>15,779|
|UK|1982|pds.<br>10,000|17,505|<br>21,424|
|uS|1980|US$ 100,000|100,000|<br>143,379|
|Yugoslavia||unlimited||unlimited|

# NOTES:

The year listed is the latest year that the ceiling was modified (to the amount specified in the first column). This amount was converted to US dollars using the average exchange rate for that year. Finally, this was reflated to 1988 dollars using the US CPI. Thus, the last column specifies the 1988 dollar value of the coverage ceiling at the last time it was changed, and no the dollar value of the ceiling in effect in 1988. Thus, if one takes the US as an example, the ceiling was set in 1980 to what would now be $143,379. Since then, the value of the ceiling has depreciated by 30S. The source for exchange rates and the CPI is the IMF's International Financial Statistics.
37

# Policy Implications of Alternative Scheme.

For purposes of analyzing the policy implications of different coverage schemes, we will return to the three coverage arrangements reviewed earlier in the study- -limited coverage, 100 percent insurance, and discretionary coverage. Most of the coverage schemes actually being used by developing and developed countries closely parallel one of these three arrangements.

A limited coverage scheme would fully protect small depositors because the coverage limit is expressly set to accomplish this result. However, limited coverage would give the banking system only partial protection against contagious bank runs because some depositors would not be fully insured and would have an incentive to start a run on banks perceived to be in trouble. Moreover, these large depositors are likely to be the most sophisticated and best informed depositors.

While limited coverage gives the banking system only partial protection against runs, it preserves a considerable degree of market discipline by depositors, thereby helping to constrain bank risk-taking. When banks fail and insurance coverage is limited, those depositors who are not fully protected become general creditors in the receivership. As general creditors, they will presumably sustain at least some loss, with the amount of the loss depending on the liquidation value of the assets in the receivership.

Limited coverage results in two types of inequities. First, small depositors obviously receive preferertial treatment compared to large depositors. Secondly, some banks benefit from limited coverage more than others, depending on the percentage of their total deposits that are insured. Since insurance lowers the risk of deposits, the cost of insured deposits should be lower than for uninsured deposits, other things being equal. Consequently, banks with a
38 high percentage of deposits that are insured would tend to have a lower cost of funds than banks with a low percentage. This funding advantage, however, could be offset if banks were required to pay insurance premiums based on the amount of their insured deposits, and the premium rate were set at a level equal to the cost of funds savings.

With 100 percent insurance, all depositors, both small and large, would be fully protected against loss. Moreover, full coverage would offer the banking system a high level of protection against contagious bank runs because depositors would have no incentive to start a run, so long as they retained faith in the ability of the insurer to meet its obligations when banks failed. On the other hand, 100 percent insurance would eliminate markes discipline because all depositors would be fully protected. As a result of this loss of market discipline, banks would tend to take greRter risks than they would with limited coverage or in the absence of deposit insurance.

A 100 *ercent insurance system would have no inequitable effects. All depositors and all banks would be treated equally because all deposits would be insured. No bank would gain a cost of funds advantage over another.

Like the other two forms of deposit insurance, the discretionary coverage system would fully protect small depositors. In addition, it would offer the banking system substantial protection against runs because the insurer could protect all depositors in a time of crisis. This protection, however, would not be as complete as with 100 percent insurance because the insurer might fail to recognize an emerging crisis and fail to extend the protection needed to preserve public confidence.

The discretionary coverage arrangement would have an adverse effect on market discipline that would lie somewhere between the other two coverage
39 schemes. Small depositors would be totally protected and, therefore, would have no incentive to discipline banks. However, these depositors typically do not have sufficient knowledge to evaluate effectively the financial condition of individual banks. Consequently, the loss of market discipline from fully protecting these depositors would not be great. A more serious loss would result from extending potential protection to knowledgeable large depoaitors.

Discretionary coverage would produce inequities in the case of both depositors and banks. Small depositors would be protected in all failures, whereas large depositors would be protected only if a failure t0-satened the stability of the banking system. Extension of de facto protection would be more likely with large failing banks than with small failing banks. This would favor depositors in large banks and would tend to give large banks a cost of funds advantage over small banks in the market for large deposits.

In weighing the pros and cons of the three alternative coverage arrangements, policy makers should consider two important factors not previously discussed. The first is the extent that stepped up bank supervision could be substituted for the erosion of market discipline from extensive or full insurance coverage. For example, it is conceivable that supervisors could fully offset the erosion of market discipline by imposing higher capital standards for banks or by subjecting bank lending and investment practices to more stringent review. Unfortunately, however, the quality of bank supervision in developing countries (as measured by the thoroughness of the supervisory process and the willingness of supervisory authorities to take strong action) varies considerably from country to country, and in some countries it may be difficult to offset the loss of market discipline by stepped up oank supervision.
40 It is also possible that the loss of market discipline could be offset by imposing risk-adjusted insurance premiums. Such premiums would act as a disincentive for banks to take undue risks. However, as will be discussed later, there are major practical problems with implementing risk-adjusted premiums. Consequently, this method for offsetting the loss of market discipline may not be feasible.

The second consideration relates to bank runs and the lender of last resort. In recent years, a number of scholars, particularly in the United States, have argued that deposit insurance is not needed to prevent bank runs because an effective lender of last resort can handle such runs if they occur.14 This view is based on the assumption that bank runs take the form of deposit transfers from weak banks to strong banks. These deposit transfers would result in no change in aggregate bank reserves and, therefore, would not produce a change in the money supply or interest rates. Consequently, the only action that the lender of last resort (presumably the Central Bank) has to take is to lend to any weak banks that become .liquid, and offset the resulting increase in bank reserves through open market sales or an increase in reserve requirements.

The problem with this argument is that things may not work out as smoothly as assumed. First, the bank run may take the form of a flight to currency, rather than deposit transfers. If so, aggregate bank reserves would be reduced, and it would be up to the Central Bank to offset this loss promptly and effectively, or run the risk of a sharp decline in the money supply and the 14 For example, see Anna J. Schwartz, Financial Stability and the Federal Safety Not. American Enterprise Institute for Public Policy Research, November 1987, and George J. Benston and George G. Kaufman, Risk and Solvency Regulation 2f Degository Institutions: Past Policies and Current Options. American Enterprise Institute for Public Policy Research, November, 1987.
41 level of economic activity. Second, weak banks that experience large scale deposit withdrawals would have to borrow extensively from the Central Bank and might run out of collateral that is acceptable to the Central Bank before the run ceases.

# Conclusion

As discussed earlier, the decision regard1-g the amount of insurance coverage is a crucial factor in constructing a DTS. The qppropriate coverage arrangement depends on a number of institutional and policy considerations, and these considerations could vary significantly from one developing country to another. Of the three coverage arrangements considered in this study, we believe that one -- 100 percent insurance -- should be avoided because it involves an untenable amount of moral hazard. This factor is undoubtedly the reason that almost all nations that have created DISs have opted for less than full deposit coverage. The real choice, therefore, is between limited coverage and discretionary coverage. The advantage of a discretionary system is that, if a contagious bank run begins, the nation has an institutional mechanism already in place to stem the bank run, assuming that the DIS has adequate financial resources to stem the run. With a limited coverage system, this mechanism is not in place. Consequently, a nation would have to resort to either of two alternatives: (1) try to stop the run by quickly implementing an implicit protection system that would protect uninsured depositors; or (2) continue to expose uninsured depositors to potential losses and rely on the lender of last resort mechanism to handle the run, irrespective of the size or form of the run.
42

# Types of Deoosits Covered

In addition to determining the amount of insurance coverage to extend to depositors, a nation must decide what types of deposits should be included and excluded from coverage. In many existing deposit insurance systems, some or all of the following types of deposits are excluded from coverage: foreign deposits of domestic banks; domestic deposits of foreign banks; interbank deposits; and deposits denominated in foreign currencies.

The four types of deposits listed above are usually J.AM deposits. Consequently, with coverage schemes that limit coverage to relatively small deposit amounts, it does not make much difference whether these types of deposits are included or excluded from coverage.

Foreign DeRosits of Dogestic Banks The major reason for covering the foreign deposits of domestic banks is that these deposits are as susceptible to a run as deposits held in domestic offices. Since one of the objectives of deposit insurance is to prevent bank runs, the exclusion of foreign deposits would run counter to the purpose of the system.

There are several arguments for excluding foreign deposits from coverage. First, such deposits basically are not part of the domestic banking system, the domestic money supply or domestic savings. Second, a higher percentage of these foreign deposits are likely to be held by non-residents than in the case of domestic deposits. Consequently, the government may be less concerned about protecting these deposits than domestic deposits. Third, it is possible that foreign deposits of domestic banks may be insured by the host country. If so, insuring these foreign deposits would result in double coverage, and some
43 arrangement obviously would have to be worked out to avoid paying off depositors twice in the event of a bank failure.

In most developing countries, the weight of the considerations probably would favor n insuring the forelgn d.posLts of domestic banks. The major factor is that these deposits are not part of the nation's banking and monetary system.

# Domestic Deposits of ForeiLgn Banks

The major reason for insuring the domestic deposits of foreign banks is that they are part of the domestic banking and monetary system -- a significant part in some developing countries. Also, by establishing the same ground rules for domestic and foreign banks, the efficiency of the banking system may be enhanced. Finally, in those countries where foreign banks conduct an active retail business, the exclusion of their deposits from coverage would result in some small depositors in the country not being insured.

The main argument against insuring the domestic deposits of foreign banks stems from the general proposition that deposit insurance should be extended only to banks that can be examined by the nation's supervisory authorities. In many cases, foreign banks are represented in a developing country by a branch. In this case, the developing country is faced with a difficult situation because it makes no sense to examine the domestic branch of a foreign bank. Typically, this branch would constitute only a small part of the foreign bank's total operations, and would have little effect on the bank's overall financial condition. This situation leaves the developing country with three choices: insure the branch without the benefit of detailed knowledge of the foreign bank's condition; exclude the branch from insurance coverage; or require all foreign banks to operate in the country through separately incorporated domestic banks
44 that can be effectively examined and evaluated. The problem with requiring a foreign banking organization to set up a domestic bank is that this bank probably would be more susceptible to failure than would a foreign bank with a domestic branch. The reason is that the domestic bank would be less diversified and may have to operate in a less stable economic environment. The offset to this argument, however, is that the foreign banking organization might support its domestic bank if it ran into trouble in order to preserve the foreign organization's reputation.

If a foreign bank is represented in a developing country by a branch, there is also the problem of double coverage if these deposits are insured in the foreign bank's own country. This potential problem could be resolved by excluding domestic deposits of foreign banks from coverage where such double coverage exists.

The balance of the considerations seems to favor insuring the domestic deposits of foreign banks, primarily because these deposits constitute part of the domestic banking and monetary system. Most nations with deposit insurance systems do insure these deposits.

# Interbank Denosits

The rationale for excluding interbank deposits from coverage is that banks are likely to be particularly well informed regarding the financial condition and operations of other banks. Consequently, these banks constitute the best potential source of market discipline, and by excluding interbank deposits from coverage, this market discipline is retained.

There are two arguments against excluding interbank deposits. First, it significantly increases the likelihood of bank runs because the best informed depositors in the nation would be unprotected. Second, if interbank deposits
45 are not covered and a bank fails, those banks that still had deposits in the failing bank would sustain losses. These losses would weaken these banks and, depending on the size of the deposits, could cause them to fail. Given the goal of deposit insurance to promote banking stability, this result seems counterproductive and could increase the total cost to the insurer.

At present, a slight majority of developing countries exclude interbank deposits from coverage. Among the developed countries, a somewhat greater majority exclude such deposits. On balance, we believe that it is better to include interbank deposits.

# Deposits Denominated in a Foreign Currency

In some countries, the deposit insurance system does not cover the deposits of insured banks that are denominated in a foreign currency. One reason is that these deposits are not viewed as part of the domestic money supply. Consequently, it is perceived that they need not be insured to protect the payments mechanism. Another reason particularly applicable to developing countries is that the insurer might not be able to acquire needed foreign exchange in order to pay off holders of foreign currency deposits. In that event, the holders of foreign currency deposits would force the insurer into bankruptcy for failing to honor its obligations.

One way to handle the problem of a possible deficiency of foreign exchange is to give the insurer legal authority to pay off foreign currency deposits in local. currency at the existing exchange rate. This procedure would allow the deposit insurance system to insure deposits denominated in foreign currencies safely. The problem with this solution is that the existing exchange rate in the nation may not be realistic and could result in the foreign currency holders suffering substantial losses.
46

# Financing Degosit Insurance

There are two major questions that must be resolved relating to the financing of deposit insurance. First, who should bear the costs of deposit insurance--that is, when depositors are protected from loss, who should absorb these losses? And second, how should the financing of deposit insurance be arranged? Should an insurance fund be set up and, if so, how large should the fund be?

# Allo.eating the Costs

In most existing deposit insurance systems, the costs of protection are absorbed ultimately by insured banks in the form of required premium payments into the insurance fund. The primary rationale for allocating the costs of deposit insurance to the banks is that they are the direct beneficiaries of the system. Deposit insurance lowers the risk of deposits and results in a decrease in banks' cost of funds. Some observers also would argue that banks should absorb the costs because banks produce the losses that must be covered.

However, there are two problems with requiring banks ultimately to absorb all of the costs of deposit insurance. First, the deposit insurance system may experience very large losses during a banking crisis. If so, the costs passed on to the banks may seriously erode their capital and push some of them into insolvency. Second, the benefits accruing to banks from insurance may bear no close relationship to the costs. If the costs exceed the benefits. the deposit insurance system, in effect, would be imposing a wtax" on the banks.

In some deposit insurance systems, the government, in one form or another, shares some of the cost burdens with the banks. For example, in India, Nigeria and the Philippines, the government made an initial capital contribution to the deposit insurance fund that could help to absorb possible future losses. Using
47 a different approach, the government in Spain shares the cost burdens by saki-ng regular contributions to the insurance fund that match the aggregate contributions provided by the banking sector.

There are also a small number of deposit insurance systems (Yugoslavia is a good example) where the costs of the system **are** absorbed entirely by the government, thereby conferring a subsidy on banks.

From a risk standpoint, deposit insurance increases the attractiveness of banking versus non-banking investments. In an extreme case, deposit insurance may be seen as impeding the development of capital markets by favoring insured debt over uninsured debt and equity. On the other hand, if deposit insurance is priced so as to compensate for the reduction in risk, this bias is eliminated. Therefore, the degree to which a bias is introduced depends on: (i) the degree of substitutability or segmentation of such markets; and (ii) whether deposit insurance in specific cases involves a tax or subsidy for the banking system and whether such tax or subsidy is passed on to depositors.

# Should a Fund be Established?

There are two basic ways that deposit insurance is financed through bank contributions. The first is to set up a fund and require banks to make periodic premium payments into the fund. The other is to levy ex post premium assessments on banks. Most deposit insurance systems have used the fund approach, and this appears to be the better alternative.

One advantage of creating a fund is that it tends to promote depositor confidence because there is something tangible for insured depositors to look to for protection. Another advantage is that a fund is built up over time, and this has the important effect of spreading out the costs to banks over time.
48 Probably the major advantage of ex post assessments is that they avoid the very difficult problem of determining the appropriate size of the fund. With ex post assessments, there is no guess work--the assessment is whatever is required to pay off insured depositors of a failed bank. Also, the ex post assessment approach avoids placing a burden on banks if, in fact, no bank failures occur.

On the other hand, ex post assessments have several major disadvantages that are responsible for their infrequent use. Most important, ex post assessments concentrate costs rather than spreading them out over time. Moreover, because bank failures tend to occur during periods of adversity, the concentration of costs comes at the worst time. Another problem is that the bank that fails and causes the assessment to be levied is the only bank that escapes the assessment. This result is obviously inequitable, especially in those developing countries where there are only a few banks to carry the burden. A third problem is that ex post assessments are likely to prove unworkable if the deposit insurance system is placed on a voluntary basis. During a period of adversity when failures are likely to occur, well regarded banks would have an incentive to drop out of the system in order to avoid assessments. As more banks left the system, the potential burden of paying the assessments would fall disproportionately on the remaining banks in the system, thereby increasing their incentive to drop out. The end result could be the collapse of the deposit insurance system, just at the time that the system is most needed. Size of the Fund It is extremely difficult to determine the appropriate size of a deposit insurance fund because it is very hard to predict the number and the size of banks that will fail over a given period, or the extent that they will be
49 insolvent. About all that policymakers can do is use their best judgment and allow for a wide margin of error.

Traditionally, policymakers have used the ratio of capital and reserves to insured deposits as their measure to judge the adequacy of the fund. There is considerable variation in the capital ratios of deposit insurance systems in existence. Logically, this variation should reflect differences in the financial condition of banks in the system and their concentration of risks. However, it is apparent that other factors are at work, probably including differences in the capability of individual nations to fund their systems.

While there are many ways to arrange the funding of a deposit insurance system, the following would be a reasonable approach. First, an initial capital contribution should be made to the fund, probably by the government. XD contribution should place the capital ratio at a level that would give the fund initial credibility in the eyes of depositors. Also, the contribution should be sufficient to handle failures that might occur in a period of adversity during the system's first several years in operation.

In addition to setting an initial capital ratio, authorities should establish a range above this initial level in which the capital ratio would be allowed to fluctuate. Given the great uncertainty regarding future losses, it would be advisable to set a fairly wide range, thereby allowing the ratio to rise to a relatively high level before taking any action to prevent any further rise.

The lachilles heel' of a deposit insurance system is catastrophic losses --huge losses that cause the system to become illiquid and/or insolvent. If a system becomes illiquid and the insurer cannot pay off depositors of failed banks, depositors of other banks will lose confidence in the system and may start bank runs. Alternatively, primary supervisors of banks, knowing that the insurer
50 would not be able to pay off depositors if they closed insolvent banks, oight allow these banks to remain in operation. **This ls** a very dangerous action because the management of an lnsolvent bank has a strong incentive to take hlgh risks in order to obtain large returns that might restore the bank to solvency. If these gambles turn out badly, the losses that the lnsurer will sustain when the bank is eventually closed wlll be even greater.

Catastrophic losses also may cause the insurer to become technlcally insolvent. It ls possible for an insurer to operate wlth a negative net worth if it has adequate fundlng sources so that it can contlnue to meet lts obligations. However, operating wlth a negatlve net worth always runs the risk of a loss of depositor confidence- -a loss that might occur suddenly as the result of some development.

It is the prospect of catastrophic losses that requires that the government play at least a backup role in financing a deposlt insurance system. First, the insurer should have the authority to borrow from the Treasury or the Central Bank in order to be able to honor its obligations. This borrowlng authority would allow supervisors to close insolvent banks without concern that their action might produce a crisis for the insurer, as well as the banking system. Second, the government should be authorlzed to inject addltional capital into the insurer in order to preserve depositor confidence in the system and to move the capital ratio back into the target range if losses should push the ratio below the range. Premium Assessment Policy As indicated earlier, most countries place the cost burden of deposit insurance largely or entirely on the banklng system ln the form of periodic premium payments (and initial capital contributions in several countries such as Colombia and Japan). The following questions inmolving premium assessment
51 policy must be addressed: (1) what should be the assessment base; (2) should the assessment rate vary depending on the riskiness of individual insured b. -s; and (3) what should be the level of the assessment rate?

# Assessment Base

The two measures that are the best candidates to be used as the assessment base are insured deposits and total deposits. Both measures have been used, with insured deposits now being employed in a substantial majority of deposit insurance systems 15 The major reason for using insured deposits as the assessment base is that it seems fair- -the assessment base should be the same as the amount of protection being extended to depositors. By contrast, using total deposits as the assessment base does not seem fair because in many cases the assessment base would exceed (perhaps by a wide margin) the amount of protection. 1 The use of total deposits would result in inequitable treatment of banks because some banks would have higher insured deposits to total deposits ratios than others and, therefore, would receive more protection relative to their assessment base.

The major reason for using total deposits is that banks always know the amount of their total deposits. Consequently, they can readily determine and report their assessment base. By contrast, banks find it difficult and costly to determine the amount of their insured deposits because they may have to

**15** Those systems that do not use insured deposits include the United States, Colombia, and Germany (which use total deposit), and Norway (total assets). **16** This argument against using total deposits as the assessment base may not apply if the deposit insurance system employs discretionary coverage and failures are frequently resolved in a way that protects all depositors, insured and uninsured alike.
52 combine the accounto of individual depositors having more than one account at the bank.

It is important to note that a deposit insurance system should never select total deposits as the assessment base solely because it is larger than insured de?osits and would result in more premium income. The reason is that the choice of a smaller assessment base can be easily offset by using a larger assessment rate.

# Fixed versus Variable Rates

The assessment rate applied to the assessment base could be the same for all banks irrespective of a bank's financial condition, or could be made to depend on the bank's overall risk. This variable rate approach would mimic the way premium rates are typically set in the private sector--the greater the insurer's risk exposure, the higher the premium.

From a policy perspective, a good case can be made for implementing a variable premium rate structure. The major reason is that a variable rate system imposes costs on banks for taking risks, and hence creates an incentive for banks to limit their risk exposure. This result is particularly desirable because it offsets, at least in some degree, the erosion of market discipline that deposit insurance produces. A variable rate system also results in more equitable treatment of insured banks. It does not seem fair that low-risk banks should have to pay the same assessment rate as high-risk banks when the latter represent a greater threat to the deposit insurance fund.

The major problem with variable rates is that they must be based on some measure of overall bank risk. As policymakers are generally aware, the measurement of overall bank risk is very complex and very difficult. First, there are many forms of bank risk and some of these forms, particularly credit
53 risk and fraud risk, are very difficult to quantify on an ex ante basis. Second, even if each form of bank risk could be measured reasonably effectively, it would be difficult to weight these various risks in order to establish some sort of schedule of variable rates. It also should be noted that the types of risks to which banks are exposed tend to shift in importance over time.

In sum, the measurement problems associated with establishing a variable rate system, though not insurmountable, are nevertheless considerable. This fact undoubtedly explains why virtually no deposit insurance systems employ variable rates, even though there are good reasons for doing so on policy grounds.1" Beyond the measurement problems, the use of variable rates also tends to have a perverse effect on banking stability by increasing premium rates on those banks that get into trouble. Such premium increases would reduce the earnings of these banks, thereby eroding their capital at the worst possible time.

Finally, it should be noted that the shortcomings of fixed premium rates could be reduced by varying the amount of capital that banks are required to hold in order to bring the overall risk profile of banks into greater balance than would otherwise be the case. However, adjusting the capital of banks on a risk basis involves the same measurement problems as adjusting insurance premiums on a risk basis.

Level_ of Assessment Rate As discussed earlier, one way to structure the financing of a deposit insurance system is to set a target range for the fund's capital ratio (capital plus reserves to insured deposits), and then maintain the fund's actual capital ratio within that range over time. Other than a capital injection, there are 17 While not a risk-adjusted premium rate scheme, Argentina offers banks a 10 percent premium refund if a bank complies with all regulations throughout the year.
54 four major cash flown that affect **the** actual capital ratio--premium payments, investment Lncome, claims payments and administratlve expenses. Of these four cash flows, the lnsurer has substantLal control over only one--premium payments. Once the assessment base has been chosen, premiun lncome is controlled over tlme by varylng the assessment rate.

In order to keep the fund's acLual capLtal ratlo wlthin the target range, the insurer could change the assessment rate periodically. Alternatively, the insurer could make premLum rebates to banks when the actual ratio moves above the upper end of the target range, or require bank& to make special assessment payments when the ratio moves b,elow the lower end of the target range. As discussed earlier, catastrophic losses that wipe out the fund or seriously impair public confidence in the fund must be handled through a capital injection by the goverument, not through large scale special assessments on banks that could seriously erode their capital and force some banks into technical insolvency. In some existing deposit insurance systems, the amount of the regular assessment is modified according to the size of the insurance fund. In Cuba, for example, a certain peso amount was targeted for the fund, and assessment rates depend on th3 deviation of the actual size of the fund from the target figure. Consequently, the size of the assessment is directly related to the losses that the fund sustains. The German scheme for savings banks and the Norwegian eheme differ from the Cuban scheme only in that the target for the fund is expressed as a percentage of outstanding claims of the institutions, rather than an absolute amount. In Spain prior to 1980, assessments could be varied entirely at the discretion of the lnsurer. In this case, the connection between the size of the fund and the level of the assessment becomes more tenuous. Llkewise, in some countries assessments can be increased, depending
55 on need. For example, the German scheme for coercial banks envisions the doubling of the assessment rate under specific circumstances. In still other countries, the size of the fund does not affect the level of assessments directly, but may make banks eligible for a rebate of their past assessments. In Belgium, unused contributions are refunded after ten years. The Colombian scheme envisions rebates when the size of the fund permits them. A somewhat different rebate program is used in the Philippines, where 60% of the net income of the system (after paying claims and expenses) is rebated yearly. Figure 1 displays in graphical form the assessment rates charged banks in various countries. As indicated, most deposit insurance systems charge up to 0.15% of deposits, but some charge higher rates. At 0.94%, Nigeria has the highest assessment rate among the compulsory systems. Chile's voluntary complementary scheme charges an even higher 1.2% rate, and this high rate partially explains why this complementary scheme never really developed. It is clear that the rates in developed countries on the whole are lower than those in many developing countries, undoubtedly reflecting the sounder condition of banking systems in developed countries.

In a few cases, such as in Colombia and Japan, banks were required to make initial capital contributions to the fund, in addition to making subsequent assessment payments. In the case of Colombia, capital contributions were expressed as a fraLtion of bank reserves and was compensated by an equal reduction in the reserve requiremdnt. However, such initial capital contributions do not seem to be popular. The more common alternative is for the fund to borrow heavily in its earlier stages when it is insufficiently capitalized, and then repay these debts and accumulate cafital over time from higher regular bank assessments" than would otherwise be the case.
56

|Surve of Cos&n of Denos|it insurance to BankR;|
|---|---|
|Yearly Bank<br>Assessment<br>Rate (%)||
|1.20|Chile (Complementary)|
|1.10||
|0.94<br>0.90|Nigeria|
|0.70||
|0.50||
|0.40||
|0.36|Argentina (w/o refund)|
|0.35||
|0.32|Argentina (w/ refund)|
|0.30|Turkey, Colombia|
|0.25||
|0.20||
|0.15|Norway|
|0.12|Spain|
|0.10|Canada, Kenya|
|0.09|Philippines|
|0.08|United States|
|0.05|India|
|0.03|Germany|
|0.02|Belgium|
|0.008|Japan|

NT: Deposit **base may** differ amoung countrLes. **These figures reflect the** latest avallable ,at&. Countrles that levy ex-post assessments **are** excluded.
57

# Conclusion

As indicated in this section, there are a variety of arrangements being used to finance deposit insurance in developing and developed countries. In general, most schemes place all or most of the cost burden on the banks, probably in recognition of the benefits that banks derive from deposit insurance. The major problem with this procedure is that banks may be required to absorb losses during a crisis that are far beyond their capacity to sustain them One alternative way to structure the financing of deposit insurance is to require banks to pay premiums that equal the benefits (primarily in the form of a lower cost of funds) that banks derive from deposit insurance. Such a system would shield banks from potentially destabilizing assessments during a crisis. It also would avoid conferring a net tax or subsidy on banks on account of deposit insurance.

While appealing in theory, this proposal would be difficult to implement because it would require the quantification of the benefits that banks derive from deposit insurance. In a voluntary system, the willingness of banks to join the system under different pricing arrangements would provide information regarding the benefits as perceived by the banks. However, no such signals would emanate from a compulsory system, and, as discussed earlier, a deposit insurance system probably must be compulsory in order to be successful over the long run.

# Investment Policy

For those DISs that involve the creation of a fund, it is necessary to decide what types of assets should be held by the insurer. In making this decision, the following considerations seem particularly important:
58 (i) In order to preserve the principal of the fund, the fund should invest in assets that have relatively little risk (including credit risk, interest rate risk and foreign exchange risk). (ii) The fund should invest in assets that are relatively liquid. One reason is to assure that the insurer can sell the assets promptly in order to meet its obligation to protect depositors.

(iii) The fund should avoid getting involved in the -location of credit among competing interests in the private sector. (iv) The sale of the assets should not have large monetary implications, or should be appropriately sterilized by the Central Bank.

The types of assets that seem to meet these requirements the best are short-term government securities and foreign exchanges (either in the form of short-term foreign bank accounts or short-term foreign government securities). As will be shown, neither of these assets are likely to fully meet the four considerations listed above. Horeover, the choice between the two assets involves policy trade offs, and the preferred alternative could depend on circumstances.

The acquisition of short-term government securities normally would involve little risk and would avoid getting the insurer involved in allocating funds in the private sector. However, in many developing countries governoent security markets are relatively thin. Consequently, the sale by the insurer of a large amount of short-term governments in the market could severely depress their price, thereby inflicting large losses on the insurer and disrupting local security markets. In order to avoid this result, the insurer might want to sell the government securities to the Central Bank. Hovever, this transaction, unlike the sale of securities to the public, vould not reduce the domstic money supply.
59 Consequently, when the insurer made a cash payment to the public in handling a failing bank, there would be a net<sup>increase in the domestic money supply. If</sup> the Central Bank possesses effective<sup>instruments of monetary control and works</sup> in coordination with the insurer, it would be<sup>possible to offset this increase</sup> in the money supply. The<sup>problem is that in many developing countries, the</sup> Central Bank may lack this ability.

The holding of foreign exchange<sup>by the fund would have several advantages</sup> over the holding of short-term<sup>government securities. First, it would avoid the</sup> problem of dumping potentially<sup>large amounts of governments on a thin domestic</sup> market (although it would entail<sup>dumping a large amount of foreign exchange on</sup> the domestic foreign exchange<sup>market, which in developing countries is generally</sup> a better market than the government<sup>security market). Second, the sale of</sup> foreign exchange in the local<sup>market would reduce the domestic money supply,</sup> thereby offsetting the increase<sup>when the insurer makes a cash payment to the</sup> public in handling a failing<sup>bank. On the other hand, holding foreign exchange</sup> would expose the insurer to<sup>foreign exchange risk. Moreover, in building up its</sup> holding of foreign exchange<sup>over time, the insurer would put downward pressure</sup> on the exchange rate.

# Admission to Insurance

In order to protect the insurance<sup>fund, banks normally should be required</sup> to be in satisfactory financial<sup>condition before being allowed into the DIS.</sup> In the case of newly chartered<sup>banks, these banks should have adequate capital</sup> and have reasonable prospects<sup>for operating profitably within several years.'8</sup> Is It is conon for new banks<sup>to incur losses during their first several</sup> years of operation until<sup>they have attained sufficient size to operate</sup> profitably. These early losses<sup>do not constituteamajor problem if a bank is</sup> well capitalized initially<sup>and the bank makes steady progress toward</sup> profitability.
60 In addition, the management of the bank should be experienced and competent and have a history of integrity in business affairs.

It is possible that when a DIS is initially created, some banks may be solvent, but below the standards set for admission to the DIS. Probably the best way to handle this situation is to grant these banks admission, subject to the condition that they meet normal admission standards within several year;, or have their lnsurance revoked. This procedure would give these banks a reasonable period of time to comply, for example by raising additional equity capital. The threat of losing their insurance would act as a strong incentive for these banks to improve their condition. Furthermore, under a compulsory system, the withdrawal of insurance would be tantamount to the withdrawal of a bank's license.

# Terminating Insurance

In addition to controlling admission to the deposit insurance system, the insurer should be authorized to terminate a bank's insurance for certain actions that jeopardize the fund. More specifically, the insurer should be able to terminate insurance if a bank engages in repeated unsafe and unsound banking practices after receiving directions from the insurer and the primary supervisor to cease such practices. In addition, the insurer should be authorized to terminate insurance if a bank repeatedly violates banking laws and prudential regulations.

In most countries with a deposit insurance system, the termination of insurance is likely to represent the<sup>t</sup> death knell for the bank involved. Consequently, it is important that the insurer's authority to terminate insurance be used in a reasonable manner. The insurer should not be authorized to terminate insurance merely because a bank has encountered serious problems due
61 to adverse economic conditions in the bank's **area** or to errors of judgment on the part of the bank' s management. Koreover, when the insurer terminates **a** bank' s insurance for appropriate reasons **(repeated unsafe** and unsound operations or gross violations of banking laws and regulations), depositors of that bank should be notified of the termination, and the insurance should remain in for¢e for a reasonable period of time to give depositors an opportunity to transfer their deposits to another bank.

# Handling Bank **Failure**

One of the major functicns of an insurer **is** to resolve failing bank situations. Accordlngly, it is important for the governmen **t** o **specify in** ?s* deposit lnsurance law what failure resolution devices the insurer can use and how these devices should be employed. In this section, we will identify several important failure resolution devices, describe how **each device** works and what are its primary effects, and suggest several criteria for choosing among alternative devices in individual failing bank situations. Failure Resolution Devices For purposes of discussion, we will focus on the folloving four failure resolution devices: insured deposit payoffs or transfers; purchase and assumption transactions; financially assisted mergers; and the provision of financial assistance to a failing bank to prevent its closure. In practice, only relatively robust DISs, such as those in the United States or Spain, use **most** or all of these devices. In many of the DISs in the developing countries, only one or two of the above devices are being employed.

With an lnsured deposit payoff, the failing bank **is** closed **and the insurer** reisburses all depositors for the full amount of their deposits up to the coverage limit. Uninsured depositors and other general crediters receive no
62 payments and become claimants in the receivership. The insurer also becomes a claimant in **the** receivership, taking the place of the insured depositors. All claimants in the receivership typically suffer some loss, as well as delays before receiving partial payments from the receivership. In many respects, an insured deposit transfer is similar to an insured deposit payoff. The basic difference is that with an insured deposit transfer, the insurer arranges for all of the insured deposits of the closed bank to be assumed by another bank. In return for assuming these deposits, the assuming bank receives a cash payment from the insurer." Typically, the deposits that the assuming bank acquires have an economic value, and the bank is willing to pay a modest premium over book value for these deposits. Consequently, the amount of cash that the acquiring bank receives is usually slightly less than the book value of the deposits assumed.

With a purchase and assumption transaction, the insurer arranges for _AU_ of the deposits of a closed bank to be transferred to another bank, along with some or all of the failed bank's assets. The insurer makes up for the difference between the book value of the deposits and the market value of the assets transferred by giving cash to the assuming bank, less any premium that the assuming bank is willing to pay for the deposits.

Having the assuming bank acquire at least some of the assets of the failing bank avoids having these assets end up in the receivership, where they must be liquidated, often at unfavorable prices. The disadvantage of transferring assets to the assuming bank is that the bank will want to carefully evaluate these assets, particularly the loans. This evaluation process could delay the 19 It also may be possible for the assuming bank to acquire some of the assets of the failing bank. If so, these assets reduce the amount of cash that the insurer pays the acquiring bank.
63 resolution of the failing bank. A **key** factor in a purchase and assumption transaction **is** that afl depositors (both insured and uninsured) are fully protected from any losses. As a result, the transaction tends to preserve public confidence in the banking system, but also erodes market discipline. A purchase and assumption transaction also say give the borrowers of the failing bank some comfort because they may be able to establish an on-going relationship with the assuming bank if that bank acquLres the borrowers' loans.

Rather than arrange a purchase and assumption transaction after a bank has failed, the insurer might arrange for the merger of the bank before it is closed. In arranging such a merger, the insurer and the acquiring bank would have to negotiate the terms of the deal, including the amount and form of the payment that the insurer would have to make to encourage the acquiring bank to take over an insolvent institution. The effects of a financially assisted merger are similar to a purchase and assumption transaction--all depositors are protected, thereby preserving public confidence, but market discipline is eroded. Also, the community involved would continue to receive banking services, because the offices of the failing bank typically would be converted into branches of the acquiring bank (as they usually are in the case of a purchase and assumption transaction). A major problem with trying to use financially assisted mergers (as well as purchase and assumption transactions) in some developing countries is that there may be no bank that is sufficiently sound to make the acquisition. Even if such banks exist, they may be unwilling to make the acquisition, at least on terms that are acceptable to the insurer. Moreover, as with a purchase and assumption transaction, the acquiring bank will want to carefully evaluate the failing bank. Indeed, the loss of time with a merger is likely to be significantly greater than for a purchase and assumption transaction. The reason
64 is that in a merger the bank acquires AUl of the assets of the failing bank, whereas in a purchase and assumption transaction the assuming bank may acquire only relatively 'cleanw assets that do not require as careful an evaluation.

Finally, the insurer could address a failing situation by providing financial assistance to the bank in order to prevent its failure. This device is most likely to be used when all depositors must be protected to preserve public confidence, and a purchase and assumption transaction or financially assisted merger either is not feasible or is not authorized under the deposit insurance law. The financial assistance that the insurer provides can take a variety of forms, depending on circumstances. If the bank is merely experiencing a liquidity problem that cannot be resolved by borrowing from the Central Bank, the insurer could provide liquidity in the form of a loan or making a deposit in the bank. More frequently, however, the bank will be experiencing an insolvency problem. In this event, the insurer might make an equity injection in the bank. Alternatively, the insurer could acquire some of the bank's nonperforming assets at p, giving the bank either cash or government securities. This transaction is tantamount to the injection of equity, and has the added advantage of giving the bank a fresh start by removing the bad assets that otherwise would have to be worked out. In providing support to an insolvent bank, the insurer typically would acquire an equity position that would make it the dominant shareholder. The insurer also would normally replace previous management that, at least in part, was responsible for the insolvency. From the perspective of the public, the effects of a financial assistance transaction are similar to the insurer arranging a purchase and assumption transaction or a merger--all depositors are protected (thereby preserving public confidence but
65 eroding market discipline) and the community continues to be served (in this case by the same bank).

Statutory Provisions In creating a DIS, the government should include provisions in the deposit insurance law relating to failure resolution devices. Moreover, these provisions should assure that the devices used by the insurer are consistent with the objectives and form of the DIS. An example will illustrate this point. Suppose that a nation is establishing a limited coverage DIS, which is expressly designed to protect small depositors, but expose large depositors to potential losses in order to maintain market discipline. In this event, the deposit insurance law should prevent the insurer from using failure resolution devices, such as purchase and assumption transactions, mergers and financial assistance, that extend de facto protection to uninsured depositors.

There are two ways that failure resolution provisions can be specified in the deposit insurance law. One way is simply to list the devices that the insurer can use. The other way is to include general language that requires the insurer to use only those devices that are consistent with the objectives and form of the system. In general, the latter approach may be the better alternative because it would give the insurer the flexibility to employ new devices over time as business practices change and as innovations in handling fail-ing bank situations are developed.

In addition to specifying the types of failure resolution devices to be used, the deposit insurance law should specify the criteria that the insurer should consider in choosing amor.n alternative authorized devices. In many DISs, the sole or dominant consideration is cost minimization. Some failure resolution devices tend to be more cost effective than others because they tend to preserve
66 the value of the failing bank's assets. These assets may lose a considerable portion of their value if they are thrown into a receivership an-i then sold at "fire sale' prices. Alternatively, if these assets are transferred to another bank as the result of a purchase and assumption transaction or a merger, the acquiring bank may be able to work these assets out over time, thereby preserving much of their value. The same savings may result if the failing bank is effectively taken over by the insurer in a financial assistance program.

While cost minimization is important, it is not the only factor that should be considered in handling failing banks. In particular, there may be occasions when cost minimization may conflict with the objectives of a DIS to preserve banking stability. For example, if a nation has a discretionary coverage scheme, the insurer may feel compelled to extend de facto protection to uninsured depositors in order to avert contagious bank runs, but find that an insured deposit payoff or an insured deposit transfer (which do not protect uninsured depositors) would be the lowest cost option. In this event, it is important that the insurer pursue the objective of preserving banking stability, even if it means employing a higher short-run cost alternative.

Other public interest factors also might conflict with cost minimization. One possible factor is the convenience of the banking public. As indicated earlier, some failure resolution devices shield depositors and borrowers from the disruptions of a failure better than others. Consequently, since the function of the banking system is to serve the public, it would seem reasonable to allow the insurer to take public convenience into account in resolving failures. Second, while some failure resolution devices employ 'private sector solutions" that transfer the assets and liabilities of the failing bank to other banks, one device--providing financial assistance to a failing bank--usually
67 results in the insurer becoming the dominant shareholder of the failing bank. This result places the assets and liabilities of the bank under the control of the insurer (a government agency) and over time usually forces the insurer, however reluctantly, to become involved in credit allocation. In some countries, this outcome would not be looked upon favorably. Therefore, in these countries the insurer could be authorized to give weight to seeking private sector solutions even though such solutions sonetimes might be higher cost alternatives. Organizational Arrangements In developing countries, there are significant differences in the way that deposit insurance corporations are organized within the national government. In India, the insurance corporation is fully owned by the Central Bank, and the corporation's board comprises representatives from the -entral B.ink and the national government. In Colombia, the insurer will be attached to the Central Bank during its first few years in operation. Thereafter, it will become an independent agency, but will be overseen by the Superintendency of Banks and will have representatives from the Central Bank and the national government on its board. The Nigerian Deposit Insurance Corporation is meant to be an independent agency, but is jointly owned by the Central Bank of Nigeria and the Ministry of Finance, and has representatives of both of these agencies on its board. The Philippines Deposit Insurance Corporation is an independent agency, but has representatives of the Central Bank and the national government on its board. In general, these DISs seem to fall into two basic organizational models, one where the insurer is part of the Central Bank, and the other where the insurer is an independent agency with managerial ties to the Central Bank and other governmental units. There are both pros and cons with having the insurer lodged in the Central Bank. In many developing countries, the Central Bank is
68 the supervisor of banks. In these cases, having the insurer in the Central Bank means that all functions relating to preserving banking stability--supervision, deposit insurance and lender of last resort--would be in the same agency. Such an arrangement would promote consistent policy making. It also should result in at least some synergies in the use of human resources.

There are probably two arguments against placing the insurance function in the Central Bank. First, if the insurer also acts as the receiver for failed banks, as some do, it would involve the Central Bank in considerable Initty gritty" liquidation activities that many would not regard as an appropriate central banking .unction. Horeover, there is evidence that Central Banks have generally proven to be ineffective at recovery and liquidation.2 0 Second, if a Central -nk served as both the insurer and the supervisor of banks, there are occasions when the Central Bank might become involved in at least the appearance of a conflict of interest. In acting as an insurer, the Central Bank might conclude that the best way to handle a failing bank situation is to extend financial assistance to the bank. Typically, when an insurer provides financial assistance, it acquires a controlling interest in the failing bank. If this were done by the Central Bank, however, the Central Bank would end up being an owner of the failing bank and that bank's supervisor.

In final analysis, there is probably no 'best way' to organize " deposit insurance corporation in the national government's organizational structure. All countries have their unique characteristics, and what is the best organizational arrangement for one country may not be best for another. What is important, however, is that the supervisory, insurance and lender of last resort functions be coordinated and operated harmoniously. This objective could

**20** World D_velopmqj. r.. 1989, p. 82.
69 be achieved in a variety of ways--putting all functions in a single agency, having multiple agencies with some overlapping management, or having multiple agencies and establishing some form of interagency coordinating committee.

When the insurance and supervisioT, functions are placed in separate agencies, there is a particular need to coordinate bank examinations because these examinations can be costly. Moreover, in most developing countries, bank examiners, especially experienced ones, are in short supply. Consequently, it is important to minimize any duplications by the insurer and the supervisor in the examination area. Probably the best way to achieve this result is to give the supervisor sole responsibility for conducting regular examinations. At the conclusio. of each examination, the supervisor would be required to send a copy of the examination report to the insurer in order to inform the insurer of the bank's financial condition. The supervisor also would be required to send the insurer copies of all relevant financial reports that banks file with the supervisor.

While minimizing duplication is important, the insurer must be authorized to conduct limited purpose examinations of failing banks in order to determine which failure resolution device would be most appropriate, given the circumstances of each case. Moreover, the insurer should be authorized to conduct an examination in those cases where an insurer is considering the termination of a bank's insurance. The insurer also should be able to issue warnings to banks about the possible termination of insurance based on findings by the supervisor that the bank has engaged in serious unsafe and unsound banking practices or serious violations of banking laws and regulations. Such warnings are like.y to be particularly effective because banks realize that the termination of insurance could lead to the demise of the bank.
70

# Su..a **n** Conclusi,n

As indicated in this section, DISs are relatively complex mechanisms and they must be properly designed In order to perform effectively. In general, these systems will function best if: (i) the system is public; (ii) bank membership in the system in the system **is** compulsory; (iii) deposits are not fully insured; (iv) the system is adequately funded and has some form of government back-up support in a crisis; and (v) the insurer can resolve failing bank situations in a variety of ways.
ARgendix A Page 1

## ARGENT

# 1. Unconditional Government Guarantee on Deposits

Origins: The government has explicitly backed deposits since 1946. The law talks about the wnationalization* of deposits, with banks simply acting in behalf of the Central Bank.

Coverage: The regulations concerning the type of banks covered, and the denomination, maturity and maximum amount of deposits insured have varied, but the concept has remained ever since. The 1946 law covered all banks, whether state owned, private or mixed, and the entire amount of demand and savings deposits. After 1957, only a partial guarancee was offered on accounts in private or mixed banks. In 1961, the guarantee was further restricted to domestic currency deposits. Over the period 1961-73, coverage was extended to other private finascial institutions not previously insured. In 1974, the limit of coverage was abolished, and guarantees were extended to all bank liabilities that served to attract resources from the public, whatever their nature.

Modalities of Operation: This guarantee simply meant that the Central Bank would pay off depositors of banks that failed, but only once its liquidation was prescribed by the Central Bank itself. Then the Central Bank would try to recover as much as possible from the liquidation of the failed bank. The role of the Central Bank was extended in 1977, when a law said that in addition the Central Bank could agree to other banks taking over the liabilities (and the ass-'ts) of a failed bank. But the Central Bank could not mandate it or make such an option attractive. Thus, in effect, it did not provide the Central Bank with any additional tools with which to handle failing or failed banks.

Financing: Entirely from the Central Bank, as required. A National Deposit Guarantee Fund was in fact established in 1971, but it was still entirely under the Central Bank. There was no functional change with the creation of the fund.

# 2. Deposit Insurance

Origins: The system existing up to 1979 was an unconditional government guarantee of deposits. After 1979 this became formal deposit insurance to the extent that banks had to make contributions to pay for the scheme. In return for having to pay for it, membership was made voluntary.

Creation: August 1979.

Membership: Voluntary, for banks and other financial institutions offering depository services. Initially, the Central Bank would automatically approve applications of existing banks. After a certain deadline, applications would have to be screened by the Central Bank. Also, member banks can withdraw from the insurance scheme at will.