Tuesday, September 8, 2009

Deposit insurance in cycle-proof regulation

In a Vox article, NYU Professor Viral Acharya makes an interesting point about the need to charge banks for the explicit guarantees issued by governments - on demand deposit insurance and temporary guarantees on debt issuance. Such gurantees are effective subsidies and imposes two types of costs - directly on taxpayers and indirectly due to induced incentives for banks to take excessive risks.

The short term liabilities of banks, in the form of demand deposits, are explicitly or implicitly insured, up to some threshold per account or individual, in most developed countries. As Prof Acharya writes,

"The capital of deposit insurance funds – which will be needed in case an insured bank cannot meet its depositors’ demands – is essentially the reserve built up over time through collection of insurance premiums from insured banks... It is thus rather surprising that most countries’ funds have no insurance premium being charged and the few countries whose funds do charge a premium (such as the US) do so in a manner that is not sufficiently risk-sensitive and unfortunately pro-cyclical, so that the funds are almost certain to be strapped for capital when insurance claims materialise."

He suggests three simple rules for how deposit insurance premium should be charged,

1. The premium should be sensitive to the risk of individual banks but also to systemic risk; that is, it should increase not only in individual bank failure risk but crucially also in the joint bank failure risk. This is because, during a systemic crisis all banks face financial constraints and it becomes difficult to sell failed banks at attractive prices, therefore leaving the deposit insurance fund with a low recovery from liquidation of failed banks' assets. This causes higher draw-downs per insured deposit.

2. The premium for large banks should be higher per unit insured deposit compared to small banks. The resolution of big banks is more costly for the deposit insurance regulator, directly in terms of losses from liquidating big banks (their failures depresses the market prices for their assets much more) and indirectly from contagion effects on other banks and the real economy.

3. The premium should be charged not just to be actuarially fair, that is, to ensure that the fund breaks even on average, but also to discourage moral hazard associated with the insurance. In particular, to discourage banks from herding and creating excessive systemic risk, the premium should charge more for systemic risk than what the actuarially-fair premium would. This is essentially because bank closure policies suffer from a time-inconsistency problem - ex-ante, regulators would like to commit to be tough on banks when there are wholesale failures, whereas ex-post, regulators show greater forbearance during systemic crises. The latter creates a collective moral hazard problem which distorts incentives for banks.

In the US, instead of a hard insurance premium target, the Designated Reserve Ratio (DDR) (of reserves to total insured deposits) is set in the range of 1.15% to 1.50%. When reserves in the Deposit Insurance Fund (DIF) fall below 1.15%, the FDIC must restore the fund and raise premiums to a level sufficient to return reserves to the DDR range within five years and when it exceeds 1.50%, the surplus would even be rebated to banks.

Deposits (savings, fixed, current, and recurring) in all commercial (including foreign) and co-operative Indian banks are insured to a maximum limit of Rs 1 lakhs by the Deposit Insurance and Credit Guarantee Corporation (DICGC), which is a subsidiary of the Reserve Bank of India (RBI). These deposits do not include deposits of governments, inter-bank deposits, and deposits held abroad. These insured banks are required to pay to the DICGC deposit insurance premium at the flat rate of 10 paise a year for every deposit of Rs 100 (or 0.01% of deposits) at half-yearly intervals.

However, the law allows DICGC to hike it to up to 0.15%. They are also required to absorb the premiums themselves, and not pass it on to the depositor. When a bank’s licence is cancelled by the RBI, the liquidator (who is appointed by the Registrar of Co-operative Societies) prepares a list of depositors holding deposits up to Rs 1 lakh and submits the same to the DICGC for settlement of claims.

In keeping with the moving target of financial market regulation, the RBI should be closely looking at increasing the deposit insurance premiums for insured deposits by taking into account the risks borne by the insured banks. In order to avoid problems relating to the higher risks borne by co-operative banks, it may be prudent to initially cover only the larger commercial banks with risk based deposit insurance premiums.

Prof Acharya lays out the case for cycle-proof and risk adjusted deposit insurance,

"The rationale for charging banks a premium on a continual basis based on individual and systemic risk regardless of the deposit insurance fund's size is that it causes banks to internalise in good times the costs of their risks (and resulting future failures) on the fund and rest of the economy. Since a systemic crisis would most likely cause the fund to fall short and dip into taxpayer funds, the incentive-efficient use of excess fund reserves is as return to taxpayers rather than to insured banks."

See also this comparative study on deposit insurance in various countries.

Update 1
The RBI is examining the possibility of transforming the Deposit Insurance and Credit Guarantee Corporation (DICGC) from a 'pay-box' system to a one attending to all aspects of bank resolution.

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