Analysis: Pros and cons of deposit insurance
Financial uncertainty inevitably leads to the revival of proposals for safety schemes. A popular one is deposit insurance, such as the comprehensive one introduced last week by Ireland’s six banks with government backing.
At the weekend, Germany also guaranteed all deposits to prevent a panic caused by the failure of a rescue plan for a leading mortgage lender, Hypo Real Estate.
Deposit insurance is popular with voters and New Zealand, with Australia, is unusual in not having a scheme.
A recent OECD report, Financial Turbulence: Some lessons regarding deposit insurance, covers some of the latest research. It cites a study of banking crises from the 1980s to the mid-1990s that found the presence of an explicit deposit insurance scheme “tends to increase the probability of such events.”
Another showed that in institutionally weak environments, such schemes “increase the probability of systemic banking problems.”
They are also not required under the 1997 Core Principles of Effective Banking Supervision prepared by the Basel Committee on Banking Supervision, which supervises central banks.
Deposit insurance has the advantages of creating financial stability and ensuring problems in one bank do not spread to another.
The downside comes from the increased risk of imprudent behaviour, as depositors are unlikely to withdraw funds that are not at risk, though this can be limited by caps or co-insurance in which the amount covered is less than 100%, and depositors are required to bear part of the costs of a banking failure.
The OECD report says explicit schemes are helpful in defining the outer limit of the financial safety net, in this case by limiting protection to “insured depositors.”
That still puts uninsured depositors, other creditors, shareholders and managers at greater risk, and therefore likely to monitor and restrict the riskiness of their bank.
This was one of the key reasons for the recent adoption of explicit depositor insurance in Singapore.
In Australia and New Zealand, where there is no explicit insurance, a potential plan was outlined in a September 2007 paper issued by the Shadow Regulatory Committee, which urged proposals for failure management arrangements and a clear delineation of the safety net boundary.
An earlier Australian study (the Davis report) concluded the costs and benefits are finely balanced. Its terms of reference meant the report did not make a recommendation on a scheme, but did outline the issues.
More recently, in 2006, the Australian Council of Financial Regulators concluded there was a strong case for at least some form of protection for depositors, and that there is widespread public support for the government to guarantee all or part of deposits caught up in the collapse of a regulated deposit-taking institution.
Another suggestion has been an “early access facility” that would complement existing depositor preference rules.
In general, the OECD report says financial safety nets require three inter-related elements: prudential regulation and supervision, lender of last resort facilities and deposit insurance.
If only one of two of these are in place, a country is “still likely to face difficulties in finding effective solutions for preventing or resolving serious problems” in the banking system.
The OECD report shows wide variance in schemes and what they cover (even before Ireland and Germany lifted their guarantees to 100%).
The US is the among countries with the highest amount covered (just increased under the bailout package from $US100,000 to $US250,000). Norway has the highest (a whopping equivalent of $US375,000), followed by Italy ($US153,000) with Canada and Mexico both around $US100,000.
Most European countries range from 20-25,000 euros ($US29-37,000). These figures (slightly higher in the UK) typically cover all but a handful of depositors and about 50% of the total value, leaving large corporate and interbank deposits exposed to market disciplines.
The rates are also adjusted from time to time to reflect inflation and other factors.
Runs not prevented
While simplicity is a virtue with deposit insurance schemes, recent experience has thrown up problems in their application.
For example, schemes with low levels of coverage and partial insurance, together with likely delays in repayment, did not prevent a run on Northern Rock, which was nationalised by the UK government and is now turning away depositors because of the implicit government guarantee.
In response to the run, the government superceded the existing deposit insurance scheme with a 100% guarantee up to £35,000 (previously only the first £2000 was fully guaranteed and 90% of the remaining £33,000).
The Northern Rock example is quoted by a sceptical article in the Economist, which says the delays in depositors getting their money meant it was more rational to withdraw cash immediately, thus adding to the run.
The Economist suggests removing all limits, so that all savers, “from paupers to princes, were fully guaranteed.” But this would make industry-funded schemes unviable, leaving governments carrying all the risk.
Ireland’s case is instructive: its 100% guarantee for all deposits is equivalent to double its GDP, compared with America’s total commercial bank exposure of three-quarters of GDP.