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Funding of Deposit Insurance Systems: Comments Jean Roy Professor of finance HEC-Montreal, Canada.

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Presentation on theme: "Funding of Deposit Insurance Systems: Comments Jean Roy Professor of finance HEC-Montreal, Canada."— Presentation transcript:

1 Funding of Deposit Insurance Systems: Comments Jean Roy Professor of finance HEC-Montreal, Canada

2 Perspective for comments As I basically agree with the paper, my comments will try to contribute to the analysis on six points, some minor, some more substantial.

3 Point 1: Two more arguments in favor of Ex ante funding Argument 1: the characteristics of disbursements made historically by deposit insurers. Argument 2: the effect of funding on dynamic efficiency.

4 Disbursements made historically by D.I. (systemic vs non systemic origin?) Historically, by far the larger part of disbursements made by deposit insurers were of a systemic origin. Ex post funding works well when disbursements are caused by non systemic risks. Ex ante funding is a better solution when disbursements are caused by systemic risks. Thus, ex ante funding should be prefered.

5 The effect of funding on dynamic efficiency A system is said to exhibit dynamic efficiency if it shows a good ability to improve through adaptation and innovation. It could be argued that deposit insurers using ex ante funding have stronger infrastructures and are both more able and prone to engage in research and evolve. This advantage with regard to dynamic efficiency would be another reason to favor ex ante funding.

6 Point 2: Hybid funding - same rationale as for liquidity management in banks A good case can be made for hybrid funding. An ex ante fund is put in place to cover most but not all conceivable needs for funds. The ex post funding arrangement is set up to be put in motion if ex ante funds are exhauted. Similar to liquidity management in banks, this solution balances effectiveness and costs.

7 Point 3: Determining the optimal size of a deposit insurance reserve A key issue. The deposit insurance reserve is similar to a stock held by a retailer. Standard inventory theory applies. The optimal stock minimizes the sum of stockouts costs and holding costs. Once this model is accepted, the process for finding the optimal solution is well known.

8 Determining the optimal size of a deposit insurance fund (cont.) One has to estimate three key factors: The stochastic distribution of demand The stockout cost The holding cost Risk aversion may also be relevant. Admittedly, all these may present difficulties to estimate for deposit insurers, but may be evaluated if enough ressources are committed to the task.

9 Relationship with the approaches proposed in the guidance paper Either the «historical experience with bank failures» or the «credit portfolio approach» are two methods to try to identify «the distribution of demand»; they may be complements rather than substitutes. The credit portfolio approach has to be favored to make deposit insurers in step with methodological developments going on in banks, under the thrust of the Basle II accord.

10 Point 4: Separate deposit insurance funds The analysis could take into account the potential benefits of economies of scale and diversification, that can make an integrated fund more solvent.

11 Point 5: Management of Deposit Insurance Funds P.27 «It is also advisable to invest funds in financial assets in the currency in which potential claims are most likely to be paid.» ? An alternative approach: «Funds should be invested such has to hedge the risk exposure.» Example: the Mexican banking crisis and more generally the phenomenon of the twin crisis (bank and currency crisis).

12 Point 6: Other types of funding arrangements The key issue is whether it is appropriate and potentially advantageous for deposit insurer to become active risks managers also in the area of financing.

13 What may be the motives for transfering risks to third parties? Two potentially valid reasons: Obtain additional funds, when conventional sources are close to fully used. Transfer risks to avoid holding a portfolio that is too concentrated, to move towards a more diversified portfolio of risks.

14 Motives for risk transfer (cont.) Two weak motives for deposit insurers Transfer risk to a party that has a lower cost of capital. Not many parties have a cost of capital lower than banks or governments. Introduce a financial instrument that will foster the production of new financial information by the market.

15 A pre-requisite: risk measurement To trade responsibly, sound evaluation of the risks traded seems a pre-requisite for the adequate pricing of these risks. It thus seems that models to evaluate the risks associated with deposit insurance must first be put in place, before any rational trading can be envisaged and organized. Thus, implementation of the credit portfolio approach to the risk measurement and solvency analysis seems the logical first step.

16 Tools to trade and transfer risks Catastrophe bonds: A bond that is not reimbursed if a specified catastrophe occurs, making the bondholder an insurer against the catastrophe Credit derivatives – credit swaps: credit insurance contracts that me may traded

17 Catastrophe bonds vs credit derivatives InstrumentCatastrophe bonds Credit derivatives Risk transfer to a third party Yes FundingEx anteEx post Credit riskNoYes CostHigherLower

18 Conclusion The purpose of the paper is: «to provide practical guidance on the design of funding arrangements for deposit insurance systems» (p. 6) Has it achieved its purpose?

19 Conclusion It deals with all the major funding issues. It presents and analyses the options. It assumes that solutions are dependant on circumstances. It offers a comprehensive set of sound advices. It should be a useful resource for professionals having to decide on funding arrangements.

20 Conclusion As my comments may have shown, the paper also implicitly raises a number of issues which are fertile ground for research. I hope that the quest for finding optimal funding arrangements for deposit insurers will be an ongoing process leading to adaptation, innovation and dynamic efficiency.

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