Deposit Insurance Policies and the Financial Crisis. David S. Hoelscher. Introduction

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1 Draft May 20, 2011 Deposit Insurance Policies and the Financial Crisis David S. Hoelscher Introduction The role of deposit insurance and depositor protection is undergoing important changes in light of the 2008/9 global crisis. Assumptions about the role of depositor protection in maintaining financial stability has evolved and its role in the safety net has been clarified and strengthened. These changes are leading to a rethinking of the optimal design features of the deposit insurance system. The global financial crisis is also changing the role of the safety net and the relation among elements of the safety net. Traditionally, the safety net was designed to allow systems to accept risk accumulation without undermining financial stability. Supervision and problem bank insolvency frameworks were directed at setting parameters for limiting risk taking by banks and the problem bank resolution framework was designed to remove banks that overextended themselves without undermining the safety and soundness of other banks. Deposit insurance, in this framework, was limited to protecting those unable to understand or monitor risk build up in the system. The crisis has led to the concern that this framework is too narrow and a more integrated approach of the safety net could strengthen efficiency. Traditionally, the design of deposit insurance systems sought to incorporate some risk exposure to all depositors. Policy makers and deposit insurance practitioners were aware that, like any insurance system, deposit insurance can make depositors relatively risk insensitive. If a portion of depositors do not demand safe and sound practices, from their banks they reduce market discipline. Policy makers responded by increasingly incorporating design features that exposed all depositors to some level of risk. Examples of such features included (i) low coverage, (ii) coinsurance, and (iii) risk based premiums. In addition, the effectiveness of deposit insurance was seen as being limited to periods of financial stability. Policies needed in stable times were considered different from those needed in a broad financial crisis. In stable times, a weak bank could fail but small-scale depositors would be protected and would not run. Unsafe and unsound behavior by banks would be punished by the market and by the supervisors. In crises, these safety net policies would be overshadowed by public policies where stability required more active public sector intervention, both in terms of protecting all creditors, including depositors (often through blanket guarantees) and public support for all financial institutions. This approach reflected the difficulties of determining which institutions are viable over the medium term.

2 2 The 2008/09 financial crisis has led to a re-examination of many of these fundamental assumptions. First, depositors have been seen as more risk-sensitive than many expected. The threat of even small losses in principle can lead to destabilizing runs. Second, the crisis emphasized the importance of having an integrated policy response, where comprehensive crisis management policies that are closely integrated. The close coordination between the supervisors, the bank resolution framework and depositor protection is now clearly seen as essential following the crisis. Finally, the traditional distinction between policies for stable and crisis times has been questioned. Difficulties in timing the shift in policy stance, questions of triggering mechanisms, and concerns about the size of contingent liabilities have all pointed to the need for a unified safety net framework. Traditional View of DIS Banking failures are disruptive. Customers lose access to their deposits, borrowers lose access to bank credit, and creditors lose value. If failures are extensive, economic growth may be disrupted. The social and political impact of these developments can be more wide ranging than the economic losses incurred during the crisis. Deposit insurance is designed to mitigate, in part, the impact of a bank failure on financial stability. Deposit insurance aims at protecting small-scale depositors. While large-scale depositors are expected to impose market discipline on banks and limit unsafe and unsound banking practices, small-scale, retail depositors are considered as relatively uninformed and unlikely to impose such discipline. By reinforcing confidence and certainty for small-scale depositors, deposit insurance limited contagion while not undermining market discipline. Deposit insurance systems expanded slowly at first but then increased rapidly over the last 25 years. The first systems were established in the Czech Republic and in Cuba in the second decade of the twentieth century. The US FDIC, the earliest established system that is still in operation, was created in For several decades, the number of deposit insurance systems increased slowly. However, there was a sudden proliferation of deposit insurance systems in the late 1980s and 1990s (Chart 1). This increase in deposit insurance systems may have been triggered by a combination of financial deepening, increasing access to finance by low and moderate income groups, and growing interconnectedness among banks. Moreover, the systemic crises that affected a wide range of countries in the 1990s the Nordic countries in early 1990s and the Asian countries in led to growing concerns about ensuring financial stability.

3 3 At the same time, concerns began to be raised about possible distortions arising from such protection. Practitioners of deposit insurance focused on the beneficial impact of limiting depositor runs and the social benefits of ensuring small-scale depositors always had access to their funds. Academics, however, raised concerns that, like any insurance system, deposit insurance could increase overall risk. If any group of creditors fails to monitor the safety and soundness of an institution, they argued, shareholders and managers could be led to take on more risk in the search for higher yield. The combination of expansion of deposit insurance systems and the possibility of increased risk taking could expose the public sector to significant contingent liabilities. Accordingly, the design of deposit insurance increasingly incorporated elements to address such fears. Policy makers were led to find design features that increased depositor exposure to risks and reduced the contingent liability facing the public sector. First, deposit insurance coverage levels were kept explicit and low. With a smaller portion of depositors covered, it was hoped that the costs to the public sector of failures would be reduced. Second, many systems began to expose all depositors to some level of risk. Coinsurance became an increasingly common design feature, where all depositors would lose some portion of their deposit (often 10 percent of insured deposits) in a failure. A third feature aimed at limiting public sector contingent liabilities was risk based premiums. Policy makers argued that those banks with the greatest risks should contribute relatively more to the funding of the deposit insurance fund. While deposit insurance had become an important element in the safety net framework, it was not universally applicable. Two cases are of particular interest:

4 4 Deposit insurance was not effective in addressing weaknesses in large, systemically important banks. Such banks were not likely to be closed and liquidated so the deposit insurance system provided no protection to depositors. The implicit full guarantee, in fact, made such banks a safe-haven in periods of financial distress. Depositors would move uncovered deposits to such banks in the expectation that the banks would never fail. 1 As the global financial markets deepened and financial institutions became more complex, the effectiveness of deposit insurance systems came under scrutiny. Financial institutions operating in different jurisdictions had different coverage levels, depending on location. These differences created incentives for depositors to move to countries with the highest level of protection. Such incentives were particularly strong in the EU and led to topping up arrangements. Policy makers also believed that a differentiation must be made between policies for stable times and policies in systemic crises. Deposit insurance was seen as a means to prevent retail depositors from running preemptively so the authorities had time to close and resolve insolvent institutions. This protection was primarily aimed at halting contagion (retail depositors from sound banks running because of uncertainty about the strength of their banks). In systemic crises, on the other hand, deposit insurance was inadequate for stabilizing expectations. In systemic crises, no one knows the true financial conditions of the system, because asset prices are changing abruptly, and future profitability of any business model was unclear. In these circumstances, full creditor guarantees and public support was needed to contain the crisis. Such major differences in the design of depositor protections can be summarized below: Stable Systemic Crisis Coverage Limited Total Funding source Banks Government Policy objective Protect small scale depositors Financial stability Burden sharing Coinsurance No coinsurance Public Policy Response to the 2008/9 Global Crisis The global crisis that emerged in mid-2008 was unusual in its speed and breadth as well as the range of countries affected. While systemic crises are not new, they have seldom affected a wide range of mature economies. The Nordic crisis in 1992 was limited to that region and the 1 The policy debate centered on whether such large banks needed to be part of the deposit insurance system at all. Most jurisdictions required such banks to participate, ensuring that the financing of the fund was shared by all banks in the system.

5 5 Asian crisis of 1998 was limited to East Asia. The systemic crises in Turkey (2001) and Argentina (2002) caused little contagion. The recent crisis, on the other hand, was unusual in its global scope. Mature economies including the US and European countries were deeply affected and the impact spread across the globe. In the years prior to the crisis, financial systems had become more complex and interconnected. Growing interconnectedness grew out of a period of aggressive financial innovation. Securitization and the creation of structured products had become key funding mechanisms for institutions. 2 The role on nonbank financial institutions the shadow banking system had likewise grown. When market pressures resulted in a collapse in the value of most structured products in 2008, financial institutions across the world faced capital deficiencies and funding difficulties. Following the crisis outbreak, public policy responses had similar elements used in past systemic crises but they differed in both scope and implementation. As in past crises, the immediate policy objective was to contain the emerging crisis. Efforts to limit the collapse of asset prices and protect institutions dominated the early stages of policy implementation. The subsequent phases of crisis management balance sheet restructuring and operational bank restructuring were less forcefully implemented. Rather than forcing loss recognition and divestment of original shareholders, policies in the current crisis put more emphasis on indirect public support to private institutions and modifications in accounting and valuation rules. Comprehensive diagnosis of bank viability and operational restructuring was correspondingly slower. The role of depositor protection also differed from past crises. In general, there were fewer bank failures than in previous systemic crises. Some countries did face significant bank failures, including Iceland, Ireland and Ukraine. In addition, the US closed a large number of small, failed institutions. However, across the board, bank failures were less of a characteristic of this crisis. Public support in the form of preferred shares and accounting forbearance was a more common response. As a result, depositor payouts or deposit-insurer-assisted bank resolutions were fewer in number. In the opening months of the crisis, policy makers struggled to maintain stability while limiting contingent liabilities for the government. Asset price declines and ratings downgrades of securitized assets in 2007 and early 2008 immediately affected bank capital through valuation losses. By end 2007, over 70 percent of banks losses came from structured products and 2 Structured products are securities whose cash flow depends on one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are affected by the value of underlying assets. Structured products may include a variety of assets including derivatives, a basket of securities, options, indices, commodities, debt issuances and foreign currencies.

6 6 securitized positions. 3 The initial policy response was less about creditor confidence but, rather, on stabilizing the financial position of individual institutions. As many of the institutions in difficulty were not banks, authorities had to find innovative responses. In general, broad creditor protection was not provided at this early stage but, rather, institutions were protected. By protecting institutions, creditors were given de facto, although not de jure guarantees. The policy mix changed following the failure of Lehman Brothers in September Although Lehman Brothers was not a bank but a nonbank financial institution, its failure and the resulting imposition of losses on creditors led to concerns about creditor stability and creditor guarantees. The market came to believe that the rules of the game were changing, unsettling markets and resulting in the threat of wide-spread creditor runs. Authorities quickly sought to enhance their deposit insurance systems and reassure creditors. Jurisdictions took two immediate steps increasing in the provision of liquidity and the extension of asset guarantees. First, central banks moved to provide substantial liquidity to the market. Such support was larger and more widespread than in previous crises. 4 New facilities were established to ease counterparty risk and collateral requirements and several central banks engaged in direct asset purchases and other unconventional quantitative interventions. Second, authorities moved to support asset prices through public sector guarantees. Rather than offer blanket guarantees to all creditors, jurisdictions in the current crisis adopted selective guarantees, targeting specific markets under distress. Specific banks were guaranteed and new debt issuances were guaranteed (Table 1). This selective support protected creditors and markets as financial distress appeared. 3 Claessens, S. et all, 2011, Crisis Management and Resolution: Early Lessons from the Financial Crisis, Staff Discussion Note 11/05, (Washington: International Monetary Fund). 4 Stone, M., K. Fujita, and K. Ishi, 2011, Should Unconventional Balance Sheet Policies Be Added to the Central Bank Toolkit? IMF Working Paper (Washington: International Monetary Fund).

7 7 Table 1. Creditor Guarantees Any change in deposit insurance Wholesale borrowing guaranteed Date of first guarantee United States 3-Oct-08 Germany 6-Oct-08 Spain 7-Oct-08 United Kingdom 7-Oct-08 Netherlands 7-Oct-08 Australia 12-Oct-08 Italy 1 13-Oct-08 Saudi Arabia 17-Oct-08 France 19-Oct-08 South Korea 19-Oct-08 Mexico 20-Oct-08 Russia 21-Oct-08 Canada 23-Oct-08 Indonesia 23-Oct-08 With asset guarantees protecting institutions, jurisdictions turned to policies aimed at reinforcing depositor confidence. Before the crisis, coverage levels in Europe averaged 1.4 times per capita GDP and, in Asia, averaged 2.2 times per capita GDP. However, there was a significant variation among countries. As the crisis spread, many countries believed that these levels were inadequate to stabilize depositor expectations. Almost 50 countries adopted some form of enhanced depositor protection. The majority of countries opted to increase significantly coverage. Over 60 percent of countries opted to increase significantly protection levels while a smaller portion (40 percent) introduced or re-introduced full depositor guarantees (Table 2). The size of the increases varied significantly across countries, ranging from 75 percent to 400 percent, reflecting a variety of domestic considerations. As a result of these actions, coverage levels in Europe increased two times to 4.8 times per capita GDP while increases in Asia were considerably higher, rising to 26 times per capita GDP. This sharply higher level of coverage in Asia may reflect, in part, the regions experiences in the late 1990s, when blanket guarantees were adopted in many crisis countries.

8 8 Table 2: Coverage Levels Coverage Ratio 1/ Old 2/ New Old New Europe Albania 700 2, Austria Belgium Bulgaria Croatia Cyprus Czech Republic Estonia Finland Germany Greece Hungary 6,000 13, Ireland Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Russia Spain Sweden Switzerland Ukraine United Kingdom Asia/Pacific region Australia 1, Indonesia 100,000 2,000, Kazakhstan 700 5, New Zealand 1, Philippines Western Hemisphere United States / Ratio of coverage level to per capita GDP.

9 9 2/ In thousands of national currencies. Most jurisdictions made permanent depositor protection a policy objective. A total of 40 countries either announced full, open-ended depositor guarantees or made significant permanent increases in coverage levels. This policy stance reflected concerns that depositors would flee if there were any chance of future losses. Seven countries announced temporary increases in coverage but several of them subsequently revised policies, making the increases permanent. Table 3: Actions Taken to Increase Deposit Insurance (As of December 2008) Full Depositor Guarantees Deposit Insurance Coverage Increase Permanent Temporary Austria Albania Australia Denmark Belgium Brazil Germany 1/ Bulgaria Netherlands Greece 1/ Croatia New Zealand 8/ Hong Kong Cyprus Switzerland Hungary 1/ Czech Republic Ukraine Iceland 1/ Estonia United States 4/ Ireland 7/ Finland Jordan Indonesia Kuwait 3/ Latvia Malaysia Lithuania Mongolia 3/ Luxembourg Portugal 1/ Kazakhstan 2/ Singapore Malta Slovakia 6/ Philippines Slovenia 3/ Poland Thailand Romania Taiwan Russia UAE 5/ Spain Sweden United Kingdom Note: Full depositor guarantee consists of guarantees covering all deposits or the majority of all deposits in the banking system. 1/ Political commitments by government. 2/ Increased from 700,000 tenge to 5 million; will revert to 1 million 1/1/12 per law. 3/ Unlimited for banks operating in country. 4/ Unlimited for non-interest bearing transaction accounts. 5/ Unlimited for local and foreign banks with significant presence in country. 6/ Unlimited for all physical persons and some categories of legal persons. 7/ Unlimited for 7 specific banks representing 80 percent of the banking system. 8/ Full coverage up to NZ$1 million per deposit. (retail deposits and non-bank deposit takers).

10 10 Many of those jurisdictions that announced temporary increases moved early to announce unwinding such protection. Among those countries introducing temporary depositor protection plans, the vast majority announced explicit expiration dates. Such announcements were included in the laws or regulations establishing the full depositor guarantees or increased deposit insurance coverage. In general, unwinding plans fell within the following three years, with the majority split between 2010 and 2011 (Table 3). Countries that have not yet determined expiration dates are generally those countries where political commitment to protect depositors has been made. Such commitments, as informal statements, often have not specified when that political commitment would expire. Effective unwinding plans must occur within a stable financial environment. Unwinding creditor protection when the markets remain uncertain can only undermine financial stability. One of the difficulties facing countries that announce unwinding programs is determining the unwinding date. Already two countries have been forced to extend their plans and, as the end dates for others approach, they will have to determine if it is appropriate. Successive extensions of extraordinary protection can slow the recovery process and prevent a return to consumer confidence. Moreover, putting the expiration date in law makes subsequent adjustment difficult Ukraine 1/ 1/1 US 12/31 Thailand 8/10 Australia 8/12 Germany 2 9/27 Denmark 2/ 9/30 New Zealand 1/ 10/12 UAE 10/12 Mongolia 11/25 Austria 2/ 12/31 Hong Kong 12/31 Greece 12/31 Ireland 2/ 12/31 Malaysia 12/31 Portugal 2/ 12/31 Jordan 12/31 Singapore 12/31 Taiwan 12/31 Slovenia 2/ 12/31 Switzerland 1/ 12/31 How Well Did Deposit Insurance Systems Function

11 11 The 2008/9 crisis is reshaping and clarifying thinking about the role and function of deposit insurance systems in financial stabilization. Performance during the crisis pointed to design features that could enhance the effectiveness of deposit insurance systems. Lessons were learned about (i) the role of deposit insurance, (ii) the scope for depositor protections, (iii) optimal coverage levels, (iv) funding limitations, and (v) payout functions. Role of deposit insurance Experience during the crisis suggests that deposit insurance systems needed to be more fully embedded in the safety net framework. Financial stability is not achieved just by protecting depositors. Rather, financial stability requires a fully articulated safety net framework where deposit insurance functions closely with and is consistent with the frameworks for bank supervision and failure resolution. The adequacy of deposit insurance design features cannot be judged in isolation from the rest of the safety net system. The issue extends beyond the sharing of information. The UK, for example, revamped the overall safety net framework by putting in place consistent revisions in deposit insurance, supervision and expanding the tool kit for bank resolution. The recognition of the importance of the overall safety net in judging the effectiveness of deposit insurance systems is reflected in the Core Principles for Effective Deposit Insurance Systems, recently promulgated by the International Association of Deposit Insurers and Basel Committee on Banking Supervision. That guidance identifies the critical functions necessary for financial stability. The allocation of those factors among safety net players is a national public policy choice. However, that choice must be explicit so that allocation of responsibilities in clear. In the build up to a crisis, jurisdictions have little time to clarify uncertainties or ambiguities in their safety net design. Scope of depositor protection in a crisis Recent developments showed the importance of protecting most creditors in a crisis. The previous practice of putting in place blanket guarantees was limited in the current crisis. Instead, authorities moved to protect institutions and asset markets as difficulties developed. For example, the US implemented a series of measures to contain the crisis: the Treasury guarantee of money market mutual funds, the FDIC increased the deposit insurance limit, the Temporary Liquidity Guarantee Program (TLGP) provided emergency insurance guarantees, the Debt Guarantee Program (DGP) guaranteed newly issued unsecured debt, and the Transactions Account Guarantee Program (TAG) provided an unlimited, free guarantee of non-interest bearing transactions deposits. While not announcing a blanket guarantee, authorities recognized the importance of stabilizing all markets in order to limit the deterioration in financial systems. Similarly, where blanket guarantees were issued by Irish authorities, it forced enhanced protection in other European nations.

12 12 Coverage Coverage levels were seen as inadequate, were increased sharply, and are likely to remain above pre-crisis levels. In any financial crisis, coverage levels invariably increase in the face of collapsing creditor confidence and runs from the banking system. In the current crisis, however, many jurisdictions opted to make coverage increases permanent. In past crises, temporary blanket guarantees were implemented to contain depositor fears. In the aftermath of the current crisis, coverage levels are likely to be permanently higher than pre- crisis. The increase in EU coverage to euro 100,000 will effectively cover over 98 percent of all depositors and 60 percent of the value of deposits. 5 Many of the newer EU members with relatively small financial systems will have 100 percent deposit coverage for all depositors. The US made the temporary $250,000 limit permanent and will fully cover 99.8 percent of depositors and 78 percent of the value of deposits. These post-crisis levels of protection are significantly higher than the often-cited 80/20 rule of thumb used prior to the crisis. These higher coverage levels reinforce the importance of integrating deposit insurance into the overall safety net. If coverage levels remain high, supervision and problem bank resolution frameworks must be able to identify excessive risk-taking quickly, have the supervisory tools to limit excessive risks, and remove quickly and efficiently failed institutions. The burden of ensuring financial stability, therefore, is shared among the deposit insurer (who protects depositors), supervisors (who indentify risks), and institutions for bank resolution (who remove failed institutions.) A number of traditional design features were found, in practice, to increase depositor fears. Many deposit insurance systems included some form of coinsurance where all depositors faced some loss (usually 10 percent of insured deposits) in the face of a bank failure. Coinsurance was designed for the dual objectives of (i) ensuring that all depositors were exposed to some level of risk and (ii) mitigating funding requirements. Events during the crisis, however, suggested that, when faced with financial distress, depositors were more risk-sensitive than expected. Depositors in Northern Rock in the UK pointed to coinsurance as one of the reasons for preemptive runs. Many systems have already dropped coinsurance and IADI s Core Principles for Effective Deposit Insurance point out the concerns coinsurance can generate. 6 A related concern was raised by the practice of deposit setoffs. Setoffs require the deposit insurer to deduct any outstanding loan owed the institution by the depositor from the deposit balance. While most jurisdictions allowed the recovery of debt service in arrears, some deducted 5 Preliminary estimates by EFDI suggest that up to 60 percent of the value of deposits will be covered under the higher coverage limits mandated by the EU Directive. 6 The discussion of coverage levels and coinsurance are containing in the Handbook accompanying the Core Principles document.

13 13 the full amount of the loan even if it is performing. Again, in the case of Northern Rock, the mortgage lender would have deducted the full amount of outstanding mortgages, effectively leaving depositors with no deposit insurance coverage. In addition, setoffs delay payout as the liquidator can calculate the eligible deposits only after an evaluation of the institution s portfolio. As a result of these developments some jurisdictions no longer apply setoff rules to performing assets. These concerns have led to a re-evaluation of the methodology for determining appropriate coverage levels. A number of techniques have been used in the past to set coverage levels. Some jurisdictions have used such rules of thumb as setting coverage at two times per capita GDP or by aiming to cover some 80 percent of all depositors but only 20 percent of the value of deposits. These techniques arose from statistical analysis of existing systems and ignore country-specific conditions. IADI s development of Core Principles for Effective Deposit Insurance suggests a more analytical approach. The appropriateness of coverage levels can be determined within the context of the overall safety-net framework. High coverage may be acceptable if combined with strong supervision and effective problem bank resolution systems. In addition, coverage levels should be set in the context of several additional factors, including: the coverage levels of in neighboring countries, any history of banking crises, high coverage levels to support financial reform. Funding Deposit insurance systems must be adequately funded to maintain depositor confidence. During the crisis, depositor payouts were limited to a few cases. The US closed a large number of small and medium sized banks, maintaining the tradition of paying out in a few days and where the fund size was more than adequate. In other cases where payout was needed, however, difficulties emerged. Perhaps the most striking example was in Iceland, where the collapse of the three Icelandic banks (Glitnir, Kaupting and Landsbanki) bankrupted the deposit insurance system (Box 1). Some jurisdictions have concluded that depositor confidence is enhanced by assurances of adequate funding. Ex ante funding not only assures that the funds are available but avoids the concern about countercyclical effects posed by ex post funding. As part of the redesign of the safety net, the UK moved to an ex ante funding system and assured adequate back-up funding. The EU is similarly considering shifting from an ex post system to a hybrid system with ex ante funding, financed through premiums, supplemented by a smaller, ex post authority.. Payout period

14 14 The crisis pointed to the importance of quickly re-assuring depositors about access to their funds. Payout delays, particularly in a crisis, created incentives for preemptive runs by depositors. In reviewing design features of deposit insurance systems, many focused on the payout period. It was considered that the previously acceptable payout periods such as three months, renewable for another three months in the EU were unlikely to be sufficient. Revisions in system designs have tried to reduce sharply payout periods. In the EU, for example, depositor payouts are now targeting at 20 working days and the UK is targeting payouts within a week. Jurisdictions recognize that shorter payout periods will require additional reforms in deposit insurance systems. Rapid payout will require early access to information about failing institutions, detailed single customer view information about deposits, more detailed information on banks credits to depositors if setoff is required, and techniques for providing rapid access to funds. These reforms are challenging and will require time to implement. Cross border integration The global nature of the crisis created two types of difficulties for depositor protection. First, unharmonized policies forced countries to respond not only to developments in their own country but also to policy decisions made in neighboring countries. The lack of a harmonized approach made crisis management less efficient. Second, in the EU, the rapid branching of institutions exposed home deposit insurance systems to unsustainable liabilities. Countries responded to domestic distress in a relatively uncoordinated manner. Deposit insurance systems differ considerably across jurisdictions and responses to financial distress respond to domestic factors. As a result, policy spill-over is a constant concern. The imposition of a blanket guarantee by Irish authorities in mid-2008 was required by domestic considerations but caught many jurisdictions unaware and forced authorities of other European nations to issue either blanket guarantees or substantially high levels of depositor protection. While stemming runs towards systems with higher coverage, country approaches to crisis management may benefit in the future from more effective coordination. The financing of cross border insurance programs was also found to be weak. In the EU, passport branching allowed the expansion of branches throughout the EU, while depositor protection was funded by the home system. In the case of Iceland, this mechanism was inadequate (see Box 1). The collapse of the large Icelandic banks posed impossible conditions on the deposit insurer. Funding of cross border funding schemes remains an area of active policy review.

15 15 Box 1. The Case of Iceland The failure of the Icelandic banking system is a good illustration of the difficulties faced in resolving institutions under current EU regulations. Shortly before the crisis, the Central Bank of Iceland set the interest rates above 15%, which led to strong capital inflows from abroad and encouraged Icelanders to borrow in other currencies. These trends, combined with exchange rate appreciation, resulted in a bubble that burst in late At the beginning of October 2008, the three largest Icelandic banks (Landsbanki, Glitnir and Kaupthing) collapsed within one week and the government had to step in to take control. Many foreign depositors with savings in accounts of Icelandic branches abroad saw their deposits frozen. Following the collapse, the UK intervened and seized the assets of Landsbanki in Britain. The branch structure of Icelandic banks activities in mainland Europe implied that the home-country DGS was responsible. However, the DIGF had inadequate funding and the Icelandic government promised to repay the UK and the Netherlands (June 2009) both countries had fully compensated depositors with accounts at Landsbanki, with the aim to recover the amounts from Iceland at a later stage. However, the compensation was turned down by the Icelandic population in a national. The case of Iceland illustrates numerous weaknesses of the 1994 Directive. Since Iceland is a member of the European Economic Area (EEA), Icelandic banks maintained branch and subsidiary structures in continental Europe, where the branch structures were not adequately backed up by the DIGF. The Kaupthing bank for instance maintained subsidiaries in Finland and Luxemburg, which then again served other countries. In 2008/09, those subsidiaries had to ask for state aid from Finland and Luxemburg in order to reimburse depositors in Finland and Belgium (from Luxemburg). The legal framework stipulates that the Icelandic DGS should have covered the branch activity in other EEA member states. Yet, the collapse of the Icelandic banking system shifted the responsibility de facto from the home to the host country. The UK and the Netherlands were under political pressure to act and calm depositors' worries. Source: Gerhardt, M., and K. Lannoo, 2011, Options for Reforming Deposit Protection Schemes in the EU, European Credit Research Institute Policy Brief No. 4 (Brussels: ECRI). Conclusions

16 16 The 2008/09 crisis led to a reexamination of the role of depositor protection and deposit insurance in the safety net. Policy makers have come to see that mitigating excessive risk taking is the responsibility of the overall safety net, not merely to be addressed through design features of the deposit insurance system. Design features aimed at increasing the exposure of depositors to risks have been modified and greater emphasis has been placed on effective and forceful supervision and effective problem bank resolution mechanisms. The design functions of deposit insurance have been revised in light of this reassessment. Many of the design features aimed at maintaining exposure of depositors to risk very low coverage levels, coinsurance, offset requirements have been replaced. Deposit insurance increasingly is focused on the financial stability requirements of complex financial markets but where depositors are exposed to relatively less risk than before the crisis. This reassessment of the role of deposit insurance has the following implications: The policy objectives for deposit insurance are likely to be broader than before, with greater emphasis on financial stability than protecting small scale, retail depositors. The relationship among safety net participants will now be more closely coordinated and, possibly, the mandate of deposit insurance systems may expand. Lowering protection is seen to be more complex, posing a problem given the sharp increases made in the aftermath of the crisis Burden sharing through coinsurance and offset requirements is seen as relatively less important, given the overwhelming importance of financial stability. Policy makers have also begun to grapple with areas traditionally at the margin of safety net design. Financial firms that are too big to fail are now being subjected to intensified supervisory oversight and specialized resolution regimes that aim at protecting the deposit insurance system. Laying out the policies and mechanisms for dealing with such firms removes an uncertainty in the role and responsibilities of deposit insurers. In addition, the distinction between deposit protection in stable times and in crisis times is disappearing. Policy makers are increasingly seeking a comprehensive safety net framework capable of ensuring financial stability in all times. In this framework, depositor protection is higher than before but buttressed by enhanced supervision and resolution techniques applicable for all institutions. The role of deposit insurance and the design of the safety net are in a period of transition. In coming years, that framework is likely to become more integrated and better designed to manage the shocks to financial systems.

17 17 REFERENCES Borio, C., B. Vale, and G. von Peter, 2010, Resolving the Financial Crisis: Are We Heeding the Lessons from the Nordics? BIS Working Paper 311 (Basel: Bank for International Settlements). Calomiris, C., D. Klingebiel, and L. Laeven, 2003, Financial Crisis Policies and Resolution Mechanisms: A Taxonomy from Cross-Country Experience, in P. Honohan and L. Laeven, eds., Systemic Financial Distress: Containment and Resolution, Chapter 2 (Cambridge: Cambridge University Press). Claessens, S., G. Dell Ariccia, D. Igan, and L. Laeven, 2010, Cross-Country Experience and Policy Implications from the Global Financial Crisis, Economic Policy, Vol. 62, pp Claessens, S., D. Klingebiel, and L. Laeven, 2003, Financial Restructuring in Banking and Corporate Sector Crises: What Policies to Pursue? in M. Dooley and J. Frankel, eds., Managing Currency Crises in Emerging Markets, Chapter 6, pp (Chicago: University of Chicago Press). Claessens, S., C. Pazarbasioglu, L. Laeven, M. Dobler, F. Valencia, O. Nedelescu, and K. Seal, 2011, Crisis Management and Resolution: Early Lessons from the Financial Crisis, Staff Discussion Note 11/05, (Washington: International Monetary Fund). Goldstein, M., and N. Veron, 2011, Too Big to Fail: The Transatlantic Debate, PIIE Working Paper 11-2, January. Gerhardt, M., and K. Lannoo, 2011, Options for Reforming Deposit Protection Schemes in the EU, European Credit Research Institute Policy Brief No. 4 (Brussels: ECRI). Hoelscher, D., and M. Quintyn, 2003, Managing Systemic Banking Crises, IMF Occasional Paper 224 (Washington: International Monetary Fund). Hoelscher, D., M. Taylor, and U. Klueh, 2006, The Design and Implementation of Deposit Insurance Systems Occasional Paper 251 (Washington: International Monetary Fund). Hoelscher, D., ed,, 2006, Bank Restructuring and Resolution, (London: Palgrave). Hoelscher, D. and Stefan Ingves, 2006, The resolution of Systemic Banking Crises, in D. Hoelscher, ed., 2006, Bank Restructuring and Resolution, (London: Palgrave). Honohan, P., and L. Laeven, eds., 2005, Systemic Financial Crises: Containment and Resolution (Cambridge: Cambridge University Press). Laeven, L. and F. Valencia, 2008, Systemic Banking Crises: a New Database, IMF Working Paper 08/224 (Washington: International Monetary Fund)., 2010, Resolution of Banking Crises: The Good, the Bad, and the Ugly, IMF Working Paper 10/146 (Washington: International Monetary Fund).

18 18 Reinhart, C., and K. Rogoff, 2009, This Time Is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press). Stone, M., K. Fujita, and K. Ishi, 2011, Should Unconventional Balance Sheet Policies Be Added to the Central Bank Toolkit? IMF Working Paper (Washington: International Monetary Fund).

41 T Korea, Rep. 52.3. 42 T Netherlands 51.4. 43 T Japan 51.1. 44 E Bulgaria 51.1. 45 T Argentina 50.8. 46 T Czech Republic 50.4. 47 T Greece 50.

41 T Korea, Rep. 52.3. 42 T Netherlands 51.4. 43 T Japan 51.1. 44 E Bulgaria 51.1. 45 T Argentina 50.8. 46 T Czech Republic 50.4. 47 T Greece 50. Overall Results Climate Change Performance Index 2012 Table 1 Rank Country Score** Partial Score Tendency Trend Level Policy 1* Rank Country Score** Partial Score Tendency Trend Level Policy 21 - Egypt***

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