Deposit Insurance Pricing. Luc Laeven World Bank Global Dialogue 2002
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1 Deposit Insurance Pricing Luc Laeven World Bank Global Dialogue
2 Introduction Explicit deposit insurance should not be adopted in countries with a weak institutional environment Political economy cannot be neglected Fair and accurate pricing is important 2
3 Questions What is a fair price of deposit insurance and how to estimate it? Can deposit insurance be priced for banks lacking publicly traded securities? Is deposit insurance underpriced? Can banks afford fair premiums? Who pays for systemic risk? 3
4 More Questions How do specific design features affect the price of deposit insurance? Should the existence of a reserve fund change the price of deposit insurance? How does financial regulation change the way deposit insurance is priced? How do risk-based capital requirements affect deposit insurance pricing? 4
5 Bank Balance Sheet Assets NPV deposit insurance Franchise value Other Assets Liabilities Deposits ❿ Insured deposits ❿ Uninsured deposits Other liabilities Equity 5
6 Method I: Equity Price Experience Deposit insurance can be modeled as a put option on the bank s assets Input parameters: Volatility of equity returns and bank leverage Regulatory capital forbearance Market-based approach Limited application to listed banks 6
7 Method II: Default Experience Expected loss pricing Credit-risk modeling approach Three components ❿ Default probability ❿ Loss given default ❿ Exposure Defaulted exposure can exceed the amount of insured deposits Expected loss versus potential loss 7
8 Estimating Default Probability Historical losses of deposit insurer Credit risk model based on bank s credit ratings or credit spreads on uninsured debt Default probability for risky debt is roughly equal to the yield over risk-free debt FDIC historical data suggests an average default probability for US banks of 0.24% 8
9 Estimating Loss Given Default Historical experience of deposit insurer US FDIC s historical loss rate equals 25% of bank assets Indicators Regulatory forbearance can be incorporated in the loss given default 9
10 Actuarial and Market Premia Actuarial premia are calculated as the historical average of expected losses Market premia include a compensation for bearing market risk and liquidity risk Historical default rates have been much lower than those implied by market prices on debt 10
11 Alternative Methods Equity model only for listed banks Credit risk model for banks with traded debt instruments or credit ratings Pricing options for other banks ❿ Hazard model ❿ Market comparable approach 11
12 Aggregation of Losses Expected loss for a portfolio of banks is the sum of expected losses for individual banks Unexpected loss for a portfolio of banks is a function of unexpected losses of individual banks and of the correlation between individual losses 12
13 Drivers of Portfolio Losses Drivers of expected portfolio loss ❿ High probability of default ❿ High loss given default ❿ Large exposure Drivers of unexpected portfolio loss ❿ High volatility of individual bank losses ❿ High correlation between individual losses 13
14 Containing the Cost of Deposit Insurance Risk diversification ❿ Non-systemic risk can be diversified away by pooling assets of banks Risk differentiation ❿ Exclusion of risky banks Limiting insurance coverage Appropriate design features 14
15 Pricing Design Features Ex-ante funding vs. ex-post funding Flat-rate premium vs. risk-based premium Levy on total deposits vs. insured deposits Broad coverage vs. narrow coverage 15
16 Comparing Design Features Coverage limit Co-insurance Foreign-currency deposits Interbank deposits Funded Compulsory membership Risk-based premium 3.2 x per capita GDP 28% of countries 68% of countries 26% of countries 87% of countries 87% of countries 41% of countries 16
17 Assessment Base Assessment base should be insured deposits otherwise there could be unequal treatment Coverage limits penalize banks with mostly large deposits if premiums are levied over total deposits Exclusion of certain deposits from insurance penalizes banks with a large share of such deposits if premiums are levied over total deposits Co-insurance as alternative 17
18 Is Deposit Insurance Underpriced? Estimated fair premiums are higher than actual premiums levied in many countries Equity price experience and limited capital forbearance suggests underpricing in about 50 percent of countries Default experience on credit ratings and a loss rate of 50% suggests underpricing in about two-thirds of countries 18
19 Pricing the Adoption of Deposit Insurance Compare with actual premiums and historical losses in other countries Estimate actuarially fair premium on the basis of the discussed methods Apply market premium markup Take design features into account 19
20 Allocation of Losses Deposit insurance premiums should at least be able to cover expected losses Actual losses, however, may exceed expected losses Risk-sharing of unexpected losses between government and private sector Systemic risk 20
21 Practical Challenges Political economy aspects Deposits are stochastic Correlations between individual losses are cyclical Deposit insurance pricing influences banks risk-shifting 21
22 Insurability of Risk Is Greater If Losses occur with high degree of randomness Maximum possible loss is very limited Average loss amount upon occurrence is small Losses occur frequently Insurance premium is high Possibility of moral hazard is low Coverage of risk is consistent with public policy The law permits the cover 22
23 Conclusions Adopting explicit deposit insurance in weak institutional environments is costly Pricing deposit insurance as accurately as possible is important but not easy There are several methods that can help in estimating fair premiums There exist several design features that can limit the cost of deposit insurance 23
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