Analyzing Deposit Insurance

At the height of the financial crisis of 2008, the US Federal Deposit Insurance Corporation (FDIC) decided to increase the deposit insurance limit from US$ 100,000 to US$ 250,000 to stem the general public’s eroding faith in the financial system. Many other countries followed suit. Australia and New Zealand, which did not have deposit insurance then, decided to introduce a 100 percent deposit insurance scheme.

As countries have realised the importance of deposit insurance, a number of countries with some form of deposit insurance scheme has increased multifold over the years. According to the International Association of Deposit Insurers (IADI), as of June 2009, 104 countries have instituted some form of explicit deposit insurance, up from 12 in 1974. Moreover, the IADI states that another 17 countries are considering implementing explicit deposit insurance in the near future.

With the recent introduction of the Deposit Guarantee Bylaw by the Deposit Insurance and Credit Guarantee Corporation (DICGC), Nepal will soon join the club of countries with deposit insurance. According to preliminary reports, Nepali banks and financial institutions (BFI) can now voluntarily decide to insure their deposits. However, the insurance scheme only applies to deposits of natural persons and not institutions or corporations. A ceiling of Rs. 200,000 per person has been applied, and BFIs registering for deposit insurance will be charged 0.2 percent or 20 paisa per Rs. 100 of deposit.

This is a welcome initiative as it will boost the general public’s confidence in the banking system. Deposit insurance is one of the most important tools to increase the public’s faith in the banking system. Diamond and Dybvig’s seminal research on bank runs and financial crises identified deposit insurance as the most viable tool to prevent bank runs and reduce contagion risk in the banking system. A run on the bank happens when the general public believes that a bank is about to go under and their deposits are at risk. As depositors rush to the bank to get their money out, the troubled bank isn’t able to fulfil all the withdrawal requests at once as a majority of their deposits are invested in long-term loans. The bank’s inability to pay its depositors creates further panic, and more depositors rush in to withdraw their savings, which ultimately leads to bank failure. Moreover, a bank run is contagious in the sense that it spreads from a troubled bank to the whole financial system like wildfire even when other banks are financially sound.

However, with deposit insurance, depositors know that they will get their money back, to the extent of the insurance coverage, even in the case of a bank failure; and there is no reason for depositors to participate in the bank run. Hence, to a large extent, deposit insurance helps prevent bank runs and contagious banking crisis by building depositor confidence. As the social and economic cost of a bank run and financial crisis are very high, institutions such as the International Monetary Fund (IMF) have been recommending deposit insurance as part of best financial practices for developing countries.

Having said that, deposit insurance, however, does create perverse incentives for both depositors as well as BFIs. Without deposit insurance, depositors are expected to carry out due diligence before putting their savings in any bank. Depositors punish financially weak and risky banks by asking for a risk premium in the form of a higher interest rate. The riskier the bank, the higher will be the risk premium, so banks are compelled to be financially sound and stable. With deposit insurance, however, depositors will no longer have to monitor the performance and activities of their bank as they will be compensated even if it were to fail. As banks face less scrutiny from depositors, they are free to indulge in risk-taking activities—a so-called moral hazard problem in economics. Banks are more than happy to pay nominal premium for deposit insurance as they no longer have to pay a higher risk premium for taking great risks.

Moreover, voluntary deposit insurance, like the one proposed in Nepal, creates another serious problem of adverse selection. The problem of adverse selection can be illustrated by the link between smoking status and mortality (adapted from Wikipedia). Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurance companies do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers. The average mortality of the combined policyholder group will be higher than the average mortality of the general population. From the insurer’s viewpoint, the higher mortality of the group which “selects” to buy insurance is “adverse”. The insurer raises the price of insurance accordingly. As a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than if they could buy it at a lower price to reflect their lower risk. The reduction in insurance purchase by non-smokers is also “adverse” from the insurer’s viewpoint, and perhaps also from a public policy viewpoint.

The same scenario can arise in the context of Nepal with voluntary deposit insurance where riskier banks may buy more deposit insurance while less risky banks may buy less or opt out of deposit insurance. Even with insurance premiums adjusted for risk-based capital fund of banks, historical evidences have shown adverse selection to be a problem for voluntary deposit insurance schemes. In a classic paper published in 1995, Kumbhakar and Wheelock found that adverse selection was one of the major problems with voluntary deposit insurance. Their study found that risky banks are more likely to join voluntary deposit insurance despite the presence of insurance premiums that were inversely related to the bank’s capital to deposit ratio.

The problem of adverse selection is due to asymmetric information where the management of a bank has a better picture of the true risk level of its balance sheet than the regulators; and depending on the riskiness of the bank’s assets, it can decide whether to enrol in deposit insurance or not. In such a context, penalising banks with higher insurance premiums on the basis of their capital adequacy ratios, as is being prescribed in Nepal, may not work.

Because Nepal is entering such a scheme, these are invaluable lessons. From a public policy standpoint, riskier banks dominating the deposit insurance scheme will be a disaster as taxpayers will have to later foot the bill if these banks were to fail down the line.

This article was first posted in the Kathmandu Post on July 21st 2010.
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