Preconditions for Deposit Insurance David C. Parker International Monetary Fund Monetary and Capital Markets Department

Preconditions What do we mean by Preconditions? Basically, the desirable circumstances necessary for a deposit insurance scheme’s (DIS) success.

Preconditions Deposit insurance systems are most effective when certain external elements and preconditions are in place If actions are necessary to address any deficiencies, then a deposit insurance system may be adopted or reformed

Preconditions Some basic preconditions: Macroeconomic stability Sound, market-based banking system Strong prudential regulation and supervision Well-developed, proper legal framework Strong accounting and disclosure regime

Economy and Banking System Assessment To be effective a deposit insurance system must be: Consistent with both the county’s economic and institutional settings Aligned with the public-policy objectives

Objectives Protect small depositors Promote financial stability by making prompt reimbursement to insured depositors in the event of a bank failure.

Economy and Banking System Assessment Deposit insurance introduction or reform process will be smoother if the health and stability of the economy and banking system are addressed beforehand

Economy and Banking System Assessment Situational analysis : Identify the conditions that could adversely affect the economy or the banking system Assess whether a deposit insurance system can be effective operating in such an environment.

Economy and Banking System Assessment - If corrective actions are necessary, they should be taken before or in concert with the adoption or reform of a deposit insurance system

Macroeconomic Stability Macroeconomic instability hampers the functioning of markets and can distort financial intermediation (i.e.) It is more difficult for banks and their clients to judge different types of risks in unstable times.

Macroeconomic Stability The introduction or reform of a deposit insurance system on its own will not be sufficient to restore macroeconomic stability Deposit insurance is not designed, nor can it be expected, to resolve a systemic crisis.

Macroeconomic Stability Authorities should analyze the conditions and factors affecting the banking system that may influence a deposit insurance system’s effectiveness before introduction

Macroeconomic Stability These may include: - The level of economic activity - Current monetary and fiscal policies - Inflation - Housing and financial assets price - Financial markets’ condition

Sound Banking System Policy makers must assess whether the entire banking system is sound, not just one institution within the system

-detailed capital adequacy evaluation Sound Banking System Assessing the banking system’s health includes: -detailed capital adequacy evaluation - liquidity -credit quality -risk-management policies and practices -extent of any other problems

Sound Banking System Assessing the banking system structure includes: - the number, type and characteristics of deposit taking institutions - the extent of competition, concentration, interconnectedness, and the ownership of institutions

Sound Banking System State dominated: When state makes credit and investment decisions, it would not be credible to claim it does not back its obligations Deposits are perceived as having full guarantee. Coverage restrictions are not meaningful

Sound Banking System System concentration - Few very large banks Would require substantial resources to compensate insured depositors TBTF – inevitably need taxpayer support to compensate insured depositors No DIS means: implicit, discretionary scheme.

Sound Banking System Small bank failures, however, can potentially affect financial stability Contagion can spread rapidly to other banks—even large banks Deposit insurance can reduce incentives for depositors to run from small banks

Sound Banking System Foreign ownership – arguments against a DIS: Foreign banks dominate the system Foreign banks have impeccable reputations Foreign banks’ parents have capacity and commitment to support the subsidiary

Sound Governance Sound governance means: independence, accountability, transparency, disclosure, and integrity Each safety-net participant is operationally independent and objectives are consistent

Sound Governance All safety-net participants should be provided with all the means necessary to fulfill their mandates The safety-net framework should clearly define the decision-making body in a time of crisis

Strong Prudential Regulation and Supervision Directly impacts a deposit insurance system’s effectiveness Only viable banks can operate and be deposit insurance members In compliance with the Basel Core Principles for Effective Banking Supervision

Strong Prudential Regulation and Supervision The supervisory authority should: - have an effective licensing or chartering regime conduct regular and thorough examinations of individual banks have a problem bank process that includes early detection, timely intervention, and resolution

Strong Prudential Regulation and Supervision Problem bank process should include early involvement of DIS: DIS should participate in examinations of CAMELS 3, 4 and 5 rated banks (regardless of mandate) DIS should be included in the resolution process, including enforcement actions and resolution strategies

Effective Legal Framework Should include a system of business laws including: corporate, bankruptcy (particularly banking bankruptcy), contract, creditor rights, consumer protection, anti-corruption/fraud and private property laws

Effective Legal Framework Highly desirable to have a special bank resolution regime (SRR) At a minimum, the SRR provides for a level of judicial review such that the bank supervisor’s decisions cannot be reversed—any successful appeals limited to monetary damages

Legal Framework Nexus with DIS Objectives Promote financial stability by making prompt reimbursement to insured depositors in the event of a bank failure. If DIS must wait to reimburse insured depositors while bankruptcy court appeal process runs its course, impossible to meet this objective

Legal Framework Nexus with DIS Objectives With SRR (and with advance preparation), DIS can make insured depositor reimbursement virtually immediately—either directly or via a P&A transaction

Effective Legal Framework The banking and deposit insurance legislation must be compatible Trigger for insured depositor repayment must be harmonized in banking and deposit insurance legislation Information exchange between the deposit insurance system and the supervisor is legally established

Effective Legal Framework Banking laws and regulations are updated as necessary Bank supervision and DIS staff are legally protected for actions taken in good faith. The deposit insurance system, or other relevant authority, can take legal action against the management of a failing bank

Accounting and Disclosure Should include comprehensive, well-defined and internationally accepted accounting principles Financial statements users must have independent assurance that accounts: provide an accurate view of the company’s financial position are prepared according to established accounting principles

Accounting and Disclosure Banks must publish financial statements periodically Banks must have an annual independent audit Investors and large depositors can use this information to increase market discipline

Accounting and Disclosure Other key elements: Additional tools for bank supervisor and DIS to evaluate individual banks’ health and banking systems as a whole Provides basis for accurate and timely insured deposit determination, necessary for prompt reimbursement Accurate data for risk-adjusted differential premium systems

Summary Basic preconditions: Macroeconomic stability Sound, market-based banking system Strong prudential regulation and supervision Well-developed, proper legal framework Strong accounting and disclosure regime

Summary The advantages of an explicit, limited deposit insurance scheme can best be realized if certain conditions are in place before its introduction.

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