Incentive compatibility and the optimal design of deposit protection schemes: An assessment of UK arrangements

Journal of Financial Regulation and Compliance

Volumn 10, Issue 2, 2002, Pages 115-134

  Hall, Maximilian J B ^a  

^a LOUGHBOROUGH UNIVERSITY   (United Kingdom)

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EID: 84867120404     PISSN: 13581988     EISSN: 17400279     Source Type: Journal    
DOI: 10.1108/13581980210810157     Document Type: Article

References (57)

1. For example, by inducing strong internal governance from owners and managers, firm discipline from the markets and effective oversight from bank regulators and supervisors.
2. Academics focus on the ‘externalities’ necessitating intervention (deposit insurance is usually one component of a wider ‘safety net’ embracing bank licensing, regulation and supervision and the provision of a ‘lender of last resort’ facility) namely, the positive externality associated with the engendering of consumer confidence in the financial system, and the negative externality in the shape of deposit runs. The latter, which is linked to the former, arises because of the inherent susceptibility of individual banks to deposit runs because of the risk and maturity transformation roles they perform - leading them to operate with a high proportion of illiquid, non-marketable loans on the assets side of the balance sheet backed, in large degree, by very short-term liabilities - and the ease with which sound banks can soon become cross-infected in the form of illiquidity and, possibly, insolvency once deposit runs start. For a summary of the theoretical and empirical literature see Hall, M.J.B. (2001a) ‘The regulation and supervision of banks’, Vol. 1, Edward Elgar.
3. Bank of England (1996) ‘Deposit insurance’, Handbooks in Central Banking, No. 9, Centre for Central Banking Studies, London, August.
4. Hanc, G. (1999) ‘Deposit insurance reform: State of the debate’, FDIC Banking Review.
5. Diamond, D.W. and Dybvig, P.H. (1983), ‘Bank runs, deposit insurance and liquidity’, Journal of Political Economy, Vol. 91, No. 3, June, pp. 401-419.
6. See Hall (2001) ‘Bank runs, deposit insurance and liquidity’, Journal of Political Economy, (Reference 2), Vol. 2, for a detailed survey of the available theoretical and empirical literature on these topics.
7. Garcia, G.G.H. (1999), ‘Deposit insurance: A survey of actual and best practices’, IMF Working Paper 99/54, April;
8. Garcia, G.G.H. (2000) ‘Deposit insurance: Actual and good practices’, IMF Occasional Paper, No. 197.
9. Notable exceptions are New Zealand and Australia. Dowd, K. (2000) ‘Bank capital adequacy versus deposit insurance’, Journal of Financial Services Research, Vol. 17, No. 1, pp. 7-15, has also challenged, from a theoretical standpoint, the need for a DIS;
10. Demirgüc-Kunt, A. and Detragiache, E. (2000) ‘Does deposit insurance increase banking system stability?', IMF Working Paper, No. 00/3, January, claim, on the basis of their empirical analysis, that ‘explicit deposit insurance tends to be detrimental to bank stability, the more so where bank interest rates are deregulated and the institutional environment is weak … the coverage offered to depositors is extensive, where the scheme is funded, and when it is run by the Government rather than by the private sector.’ Apart from questioning the desirability of a DIS, especially for developing countries, their research does demonstrate the dangers associated with a poorly-designed scheme (eg one offering too high a level of coverage).
11. An explicit DIS is superior to an implicit one because of the ambiguity and uncertainty associated with the latter. Moreover, a limited explicit DIS is likely to involve a lower level of expenditure than a system offering implicit protection (eg through ad hoc compensation payments, arranged mergers, bank recapitalisation, removal of banks’ bad debts, etc.) when resolving bank failures.
12. This section rests heavily on Hall, M.J.B. (2001b), ‘How good are EU deposit insurance arrangements in a bubble environment?' in ‘Asset price bubbles: Implications for monetary and regulatory policies’, Research in Financial Services: Private and Public Policy, Vol. 13, pp. 145-193, JAI Press Inc.
13. In the long run, however, as noted earlier, a lack of effective market discipline (ie a poor incentive structure) is likely to undermine the scheme’s stabilising capacity, indicating that the trade-off is only short run.
14. Hall, M.J.B. (1987) ‘The deposit protection scheme: The case for reform’, National Westminster Bank Quarterly Review, August, pp. 45-54.
15. Garcia (1999) ‘The deposit protection scheme: The case for reform’, National Westminster Bank Quarterly Review, August, pp. 45-54.
16. Moral hazard arises in all insurance situations. It relates to the distortion to normal behaviour induced by the provision of an insurance contract. With respect to deposit insurance, it affects both depositors - they are likely to be less concerned with their initial choice of bank and less interested in subsequently moving funds around the system, whatever the industry developments, in the face of deposit insurance - and bank owners/managers who, knowing that runs are less likely, may take on board additional risk (in the expectation of higher return), at little or no extra cost, and reduce capital and liquidity reserves. It is particularly acute for institutions that are insolvent or close to insolvency, as owners, who enjoy limited liability, have little to lose from gambling for resurrection. Adverse selection relates to scenarios where market choices about inclusion yield sub-optimal outcomes, ie when the agents who are most likely to produce the adverse outcome insured against are those most likely to take advantage of the insurance policy. In the case of deposit insurance the danger is that the weak displace the sound if the scheme is voluntary and premiums are not risk-adjusted, as banks attempt to eliminate cross-subsidies. Finally, agency problems arise whenever an agent pursues his/her own interests rather than those of the principal in an agent/principal relationship. With respect to deposit insurance, such problems can arise in the bank/depositor relationship (conflicts of interest), the deposit insurer/government relationship (‘political capture’), the deposit insurer/industry relationship (‘regulatory capture’), and the deposit insurer (or supervisor)/taxpayer relationship (‘forbearance’), see Hanc (1999) ‘The deposit protection scheme: The case for reform’, National Westminster Bank Quarterly Review, August, pp. 5-6.
17. To ensure the DIS is not left with the weakest institutions as its members, which is likely to call for ever-increasing levies and further exit from the scheme.
18. To encourage large depositors and sophisticated creditors to discipline their banks, eg through monitoring, demanding interest rates commensurate with perceived risk, and removing their funds when necessary.
19. This has proved to be of particular importance given that supervisors are prone to ‘forbearance’, a major cause of the escalation in costs associated with the resolution of both the savings and loans débâ cle in the USA in the 1980s (see Kane, E.J. (1985) ‘The gathering crisis in federal deposit insurance’, MIT Press, Cambridge, Mass.)
20. more recently, of the banking crisis in Japan (see Hall, M.J.B. (1999a) ‘Deposit insurance reform in Japan: Better late than never?', Journal of Financial Services Research, Vol. 15, No. 3, pp. 211-242).
21. Source: Garcia (1999) ‘Deposit insurance reform in Japan: Better late than never?', Journal of Financial Services Research, Vol. 15, No. 3, pp. 211-242.
22. A similar argument has been used to exclude deposits held with the foreign branches of domestic banks and with the domestic branches of overseas banks but, in the EU at least, they are included in DISs (mainly because of the overwhelming desire to establish a ‘single market’ in financial services).
23. The FSA, when justifying its decision to protect fully the first £2,000 of protected deposits within the new scheme introduced in 2001 (see FSA (2000) ‘Financial services compensation scheme, draft rules’, Consultation Paper No. 58, London, July), argued that this sum was necessary to protect fully the ‘working capital’ of an average wage earner (earning £400 per week).
24. Although the FDIC in the USA was mandated, by the FDICIA legislation of 1991, to examine a scheme based on per depositor protection, such a transition has not, to date, been attempted in that country (see Hall, M.J.B. (1993)) ‘Banking regulation and supervision: A comparative study of the UK, USA and Japan’, Edward Elgar, Ch. 5
25. Hanc (1999) ‘Banking regulation and supervision: A comparative study of the UK, USA and Japan’, Edward Elgar, (p. 6).
26. The latter tend to be ‘privately-run by member institutions, do not have clearlyspecified responsibilities regarding the sharing of the costs of compensation, lack back-up funding from the government, offer co-insurance, are limited in their role and responsibilities, and have difficulty in obtaining information from the supervisor and the central bank’ (Garcia (1999) ‘Banking regulation and supervision: A comparative study of the UK, USA and Japan’, Edward Elgar). Unsurprisingly, the former have proved most popular in recent times.
27. As noted in Hall (2001a) ‘Banking regulation and supervision: A comparative study of the UK, USA and Japan’, (Edward Elgar). Unsurprisingly, the former have proved most popular in recent times (in Ref. 2), Vol. 2, it is very difficult to establish an optimal, risk-related premium structure because of the difficulty of accurately forecasting the degree of risk which each bank will ultimately place on the fund. Thus, while some argue that deposit insurance systems should employ the options-pricing methodology initially developed by
28. Black, F. and Scholes, M. (1973) ‘The pricing of options and corporate liabilities’, Journal of Political Economy, Vol. 81, pp. 637-654
29. following the pioneering work by Merton, R.C. (1977) ‘An analytical derivation of the cost of deposit insurance and loan guarantees: An application of modern option pricing theory’, Journal of Banking and Finance, Vol. 1, pp. 3-11, June, the assumptions employed act to introduce a bias into the calculation of ‘fair’ premiums. Accordingly, many believe that the construction of an actuarially-sound, risk-related premium structure is impossible, thereby necessitating an intensification in the regulatory and supervisory effort if the resultant problems (especially moral hazard) are to be overcome.
30. In the USA, risk premiums are related to levels of capital adequacy (both in respect of the Basle-based risk assets ratio and the internally-imposed gearing ratio - see Hall (1993) ‘Banking regulation and supervision: A comparative study of the UK, USA and Japan’, Edward Elgar).
31. Unsurprisingly, the former have proved most popular in recent times (in Ref. 21), (Ch. 5) and the supervisory rating of ‘soundness’. But even here the gradations have been fairly minor - initially ranging from 23 basis points to 31 basis points but currently 0 to 27 basis points - reflecting the difficulty of precisely calculating risk and the problems associated with imposing additional burdens on banks which may already be under severe strain (see Hanc (1999) ‘Banking regulation and supervision: A comparative study of the UK, USA and Japan’, Edward Elgar). Unsurprisingly, the former have proved most popular in recent times, (p. 12) and, more recently, the problems posed by the capping of the Bank Insurance Fund at 1.25 per cent of insured deposits (see Ref. 24).
32. In the USA, over 90 per cent (ie the highest quality) of banks pay no levies because the Bank Insurance Fund is above its target level of 1.25 per cent of insured deposits - as of 31st December, 2000 it stood at 1.35 per cent.
33. Garcia (1999) In the USA, over 90 per cent (ie the highest quality) of banks pay no levies because the Bank Insurance Fund is above its target level of 1.25 per cent of insured deposits - as of 31st December, 2000 it stood at 1.35 percent.
34. FSA (2000) In the USA, over 90 per cent (ie the highest quality) of banks pay no levies because the Bank Insurance Fund is above its target level of 1.25 per cent of insured deposits - as of 31st December, 2000 it stood at 1.35 percent. (in Ref. 20).
35. The Building Societies Investor Protection Scheme is ignored because it has never been activated.
36. Financial Services Consumer Panel (1999) ‘Financial Services Consumer Panel response to FSA consultation paper 24 -Consumer compensation: A further consultation’, London, September.
37. The IMF advises that coverage be limited to between one and two times per capita GDP, the UK recording a figure of 1.4 in 1999 (see Garcia (1999) ‘Financial Services Consumer Panel response to FSA consultation paper 24 -Consumer compensation: A further consultation’, Table 5).
38. For a discussion of the current flaws in the US federal deposit insurance arrangements and a possible remedy see Wilcox, J. (2001) ‘MIMIC: A proposal for deposit insurance reform’, Journal of Financial Regulation and Compliance, Vol. 9, No. 4, pp. 338-349.
39. For further details of the schemes operating in the EU see Hall (2001b) ‘MIMIC: A proposal for deposit insurance reform’, Journal of Financial Regulation and Compliance, Vol. 9, No. 4, pp. 338-349, (in Ref. 10).
40. Bank of England/SIB (1996) ‘Deposit protection and bank failures in the United Kingdom’, Financial Stability Review, No. 1, London, Autumn, pp. 38-43.
41. Hall, M.J.B. (1991) ‘Financial regulation in the UK: Deregulation or regulation?', Ch.5, pp. 166-209 in Green, C.J. and Llewellyn, D.T. (eds) ‘Surveys in monetary economics, Vol. 2: Financial markets and institutions’, Basil Blackwell.
42. Jarman, H.W. (1994) ‘A critique of the UK approach to the supervision of building societies’, Ch. 4, unpublished PhD thesis, Loughborough University.
43. Financial Services Consumer Panel (1999) ‘A critique of the UK approach to the supervision of building societies’, Ch. 4, unpublished PhD thesis, Loughborough University.
44. Hall, M.J.B. (1999b) ‘Handbook of banking regulation and supervision in the UK’, (3rd) edition, Edward Elgar, Chapter 11.
45. Maude, D. and Perraudin, W. (1995) ‘Pricing deposit insurance in the United Kingdom’, Bank of England Working Paper Series, No. 29, Bank of England, March.
46. EC (1994), ‘Deposit guarantee schemes directive’, Directive 94/19/EC of the European Parliament, Brussels, May.
47. For a discussion of the deficiencies in the DGD see Dale, R. (2000), ‘Deposit insurance in theory and practice’, Journal of Financial Regulation and Compliance, Vol. 8. No. 1, pp. 36-56
48. Financial Times Publishing (1999) ‘A new role for deposit insurance in Europe’, ‘Statement of the European Shadow Financial Regulatory Committee’, pp. 16-17, November
49. Hall (2001b) ‘Deposit guarantee schemes directive’, Directive 94/19/EC of the European Parliament, Brussels, May.
50. Hall (1999a) ‘Deposit insurance in theory and practice’, Journal of Financial Regulation and Compliance, Vol. 8. No. 1, pp. 36-56.
51. The position of credit unions has yet to be clarified.
52. The schemes protect deposits held with foreign branches (in both EU and non-EU countries) of domestic banks and with domestic branches of participating EU and non-EU banks.
53. The position of credit unions has yet to be clarified.
54. As evidenced by the use of the Deposit Protection Scheme (DPS).
55. As apply under the new deposit subscheme.
56. See Hall (1999b) As apply under the new deposit subscheme (in Ref. 36), Chapter 11.
57. The IMF advises that coverage be limited to between one and two times per capita GDP, the UK duly recording a figure of 1.4 in 1999 (see Garcia (1999) As apply under the new deposit subscheme (in Ref. 36), Chapter 11 Table 5).