Deposit Insurance: How Much of it is Insurance!
Dr. K. C. Mishra
Director,
National Insurance Academy,
Pune
(In June, 2003 the Honorable
Speaker of Lok Sabha convened a review meeting in his chamber regarding
expanding the scope and utility of deposit insurance in India. The meeting was
attended by dignitaries from the government. The author presented his views
through this paper. This paper aims to provide guidelines for the pricing of
deposit insurance through several methodologies that can be used to set
benchmarks for the pricing level of deposit insurance in a given situation, and
quantify how specific design features affect the cost of deposit insurance.
Deposit insurance is unlikely to be a viable option with weak banks and
institutions.)
Countries that introduce
explicit deposit insurance make many decisions: which classes of deposits to
insure and up to what amount, which institutions should participate, who should
manage and own the deposit insurance fund, and at what levels premiums should
be set.
Actual contributions can be
made on an ex-ante basis, in which case contributions are typically accumulated
towards a deposit insurance fund or reserve, or on an ex-post basis, in which
case institutions pay deposit insurance levies only after institutional
failures occur.
First, deposit
insurance can be over- or underpriced.
Second, the estimate of the
fair price of deposit insurance may be biased.
Third, the government may
contribute funds or issue guarantees on certain institutional liabilities.
Fourth, actual contributions
are not always smoothed over time, unlike fair premiums that are typically
calculated as annual annuities. For instance, many countries establish target
fund levels. Once the fund achieves its target level, contributions may be (close
to) zero. Also, countries may decide to set contributions high initially in
order to quickly reach a certain minimum fund size.
Central to any deposit
insurance pricing method is a methodology to estimate the risk of the value of
an institution’s assets. To estimate institution risk and set deposit insurance
premiums, regulators typically use (a combination of) qualitative indicators
collected from on-site and off-site institutional examinations, together with
accounting-based indicators, such as CAMELS-type indicators.
In Finance literature,
several methods have been developed that make use of market-based indicators.
Most of these methods are based on Merton (1977)’s option-pricing model that
models deposit insurance as a put option on the institution’s assets. Another
approach of pricing deposit insurance is known as “expected loss pricing”. This
approach is centered around the expected default probability of an institution,
which can be estimated using fundamental analysis and/or market analysis. Fundamental
analysis is typically based on CAMELS-type ratings, and thus on accounting
values. Market analysis is typically based on interest rates or yields of
uninsured debt, such as certificates of deposits (CDs) or subordinated debt or
debentures.
The principle of expected
loss pricing is simple, and can be represented by the following equation:
Expected loss = Expected
default probability * Exposure * Loss given default.
In the above equation, the
“Expected loss” equals the size of the loss to the deposit insurer as a
percentage of insured deposits, and thus measures the cost of deposit
insurance. In order to breakeven in expectation, the deposit insurer should set
a premium per insured deposit equal to the expected loss price. The “Exposure”
is usually equal to the amount of insured deposits, but can be set equal to
total deposits (uninsured plus insured deposits) in “too big too fail” cases.
“Loss given default”
indicates the size of the loss to the deposit insurance fund as a percentage of
the total defaulted exposure to all insured deposits, and thus indicates the
severity of the loss. Good indicators for the loss given default may include
the business mix of institution, its loan concentration, and the structure of
institution liabilities. Estimates of losses given default are typically also
based on historical experience.
Institution membership of
the deposit insurance system can be compulsory or voluntarily. To reduce
adverse selection, membership should be compulsory. To encourage depositor
discipline, some countries require depositors to bear risk on their deposits by
adopting a system of coinsurance. Proper coinsurance covers the smallest
tranche of deposits in full, and imposes a haircut on larger deposits. This
fosters market discipline by the larger depositors, who are expected to have
better access to the necessary information to exercise market discipline than
small depositors.
Limiting the coverage of
deposit insurance is the most common way to contain moral hazard, and therefore
to reduce the price of deposit insurance. Limits render deposit insurance
partial. The coverage limit should be low enough to encourage large depositors
and creditors to monitor the institution and exercise market discipline. Limits
on the insurance coverage expose some depositors to the risk of loss in the
event of institutional failure and provide incentives for demanding higher
deposit rates from weaker institutions or for withholding funds entirely from
troubled institutions. Market discipline can also be achieved by excluding
certain types of deposits or liabilities.
Concept of captives
A pure captive is an
insurance company established by noninsurance organization solely for the
purpose of underwriting risks of the parent and its affiliates. An association
or group captive (Trade association insurance company) is an insurance company
established by a group of companies to underwrite their own collective risks.
After some confusion in June
2001 USA IRS announced tax deduction for contribution for risk management both
for group and single parent captives but retained the right to challenge the
transactions of single parent captives in case of suspicion. The most recent
waves of captives followed enactment of the federal Risk Retention Act 1986.
The 1986 Act authorized two mechanisms for group treatment of liability risks:
Risk retention group is a
group-owned insurer whose primary activity consists of assuming and spreading
the liability risks of its members. Insurance purchasing groups are not
insurers and do not retain risks but only purchase insurance on a group basis
for their members.
Deposit insurance is mostly
designed with social over-weightage than economic view of the schemes. Explicit
deposit insurance schemes appeal increasingly to policymakers. First, an
explicit scheme supposedly sets the rules of the game regarding coverage,
participants, and funding. Second, an explicit scheme is appealing to
politicians because it protects small depositors without immediate impact on
the government budget. One should, however, not ignore the potential cost of
deposit insurance. Deposit insurance reduces the incentives for large
depositors to exert market discipline on banks, and encourages banks to take on
risk. This form of moral hazard has received a lot of attention in the deposit
insurance economic view.
Research results show that
significant portions of the variation in the effectiveness of risk control are
explained by differences in contracting environments. On balance, explicit
deposit insurance expands risk-shifting opportunities in poor contracting
environments, but this effect is reduced in systems that impose appropriate
combinations of loss-sharing rules, risk-sensitive premiums, and coverage
limits
Limiting the coverage of
deposit insurance is the most common way to contain moral hazard, and therefore
to reduce the price of deposit insurance. Limits render deposit insurance
partial. The coverage limit should be low enough to encourage large depositors
and creditors to monitor the banks and exercise market discipline. Limits on
the insurance coverage expose some depositors to the risk of loss in the event
of bank failure and provide incentives for demanding higher deposit rates from
weaker banks or for withholding funds entirely from troubled banks. Market
discipline can also be achieved by excluding certain types of deposits or bank
liabilities, for instance, inter-bank deposits. Appendix to this paper provides
data for various active deposit insurance countries of the World.
For premium base % of assessment % of value
deposits %
of insured
of total deposits
Argentina Insured
deposits 0.66
to 1.02 40.0
0. 66-1.02
Bahamas Insured
deposits 0.05
11.5 0.05
Bangladesh Total
deposits 0.01
31.0 0.02
Belgium Insured
deposits 0.02
n.a. 0.02
Brazil Total
deposits 0.30
43.0 0.70
Bulgaria Insured
deposits 0.50
<35.0 0.50
Canada Insured
deposits 0.04
to 0.33 35.9
0. 04 to 0.33
Croatia Insured
deposits 0.80
68.0 0.80
Czech Rep. Insured
deposits 0.50
n.a. 0.50
Denmark Insured
deposits Max.
0.20 <50.0
Max. 0.20
Finland Insured
deposits 0.05
to 0.30 40.0
0.05 to 0.30
Germany Insured
deposits 0.01-0.11
n.a. 0.01-0.11
Guatemala Insured
deposits 1.00
n.a. 1.00
Hungary Insured
deposits 0.16-0.19
48.0 0.16-0.19
Iceland Insured
deposits 0.15
n.a. 0.15
For premium base % of assessment % of value
deposits %
of insured
of total
deposits
India Total
deposits 0.05
72.0 0.07
Ireland Insured
deposits 0.20
n.a. 0.20
Jamaica Insured
deposits 0.10
33.5 0.10
Japan Insured
deposits 0.08
100.0 0.08
Kazakhstan Insured
deposits 0.13-0.38
n.a. 0.13-0.38
Kenya Total
deposits 0.15
16.0 0.94
Korea Total
deposits 0.05
100.0 0.05
Latvia Insured
deposits 0.30
18.7 0.30
Lithuania Insured
deposits 1.00
44.0 1.00
Macedonia Insured
deposits 0.01-0.03
99.0 0.01-0.03
Mexico Total
deposits 0.40-0.80
100.0 0.40-0.80
Nigeria Total
deposits 0.94
21.0 4.46
Peru Insured
deposits >0.65
n.a. >0.65
Portugal Insured
deposits 0.08
to 0.12 n.a.
0.08 to 0.12
Romania Insured
deposits 0.30
to 0.60 n.a.
0.30 to 0.60
Slovak Rep. Insured
deposits 0.10
to 0.30 47.0
0.10 to 0.30
Spain Insured
deposits 0.10
60.0 0.10
Sweden Insured
deposits Max.
0.50 n.a.
Max. 0.50
Taiwan Insured
deposits 0.05-0.06
45.0 0.05-0.06
Tanzania Total
deposits 0.10
12.0 0.83
Trinidad
&
Tobago Total
deposits 0.20
34.1 0.59
Turkey Insured
deposits 1.00-1.20
100.0 1.00-1.20
Uganda Total
deposits 0.20
26.0 0.77
Ukraine Total
deposits 0.50
19.0 2.63
United
Kingdom Insured
deposits <0.30
n.a. <0.30
United States Insured
deposits 0.00-0.27
65.2 0.00-0.27
Venezuela Insured
deposits 2.00 n.a. 2.00
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