Deposit Insurance Seminar for Sr. Bank Supervisors F. Montes-Negret, Sector Manager, LCSFF The World Bank, Oct. 24, 2002
Agenda A. Introduction B. The Theory: Deposit Insurance & Risk Objectives Pros and Cons Size of the Insurance Fund Measuring Risk Pricing Loss-sharing C. The Mexican Case: FOBAPROA vs. IPAB D. Conclusions Bibliography 2
A. Introduction Regulators recognize the inherent instability of the banking system due to the fact that: (1) liquid liabilities exceed by far liquid assets; (2) the nature of the deposit insurance contract; and (3) the high leverage of banks (D/A). Then the need for a safety net. Demand deposits are characterized by two features: (1) Claims are redeemed on a first come, first served basis (sequentially); and (2) Full pay or no pay method. 3
Introduction (cont.) Banks respond to deposit losses by drawing down their cash, selling liquid assets and borrowing short-term. Beyond that they hit a liquidity crisis and if they must continue to sell fast assets at fire-sell prices, then they might become insolvent. Then a deposit insurance fund provides another defense to prevent depositors from over-reacting. The key issue is how to develop incentive-compatible deposit insurance systems. 4
Introduction (Cont.) Deposit insurance is only one of the components of the financial safety net: Sound legal regime; Stable macroeconomic environment; Compliance with recognized accounting & auditing standards; Adequate Chartering Function (licensing); Strong Prudential Supervision Function; Strict Termination Authority (de-licensing); Incentive-compatible Deposit Insurance System; Adequate Lender of Last Resort Function; Effective Disclosure Regime. 5
Introduction (Cont.) The Rediscount window is no substitute for a deposit insurance fund because: (1) to borrow from the discount window the bank needs high quality liquid assets to pledge; (2) Borrowing is not automatic but discretionary; and (3) Central ban loans are meant to provide temporary liquidity to solvent banks. Incentive-compatible deposit insurance should increase: (1) shareholders discipline; (2) depositors discipline; and (3) Regulatory discipline. 6
Introduction (cont.) Key attributes of an effective Deposit Insurance System: Explicitly defined benefits (coverage & limits); Mandatory bank participation; Clear mandates and responsibilities for the deposit insurer; Close coordination among the agencies involved; Well-defined funding mechanism for the deposit insurer; Public information campaign. 7
Introduction (cont.) Spectrum of Deposit Insurance Systems: Paybox: pays claims of depositors after a bank is closed; Risk-minimization systems: control entry/exit into the system, assess and monitor risks, conduct examinations of banks, provision of financial assistance and intervention powers, resolving bank failures and finding least cost solutions. I will focus on the latter, although not all functions might be performed by the deposit insurer. 8
B. Deposit Insurance: Objectives To prevent bank runs and enhance the stability of the financial system (remember banks are highly leveraged institutions with a high share of illiquid assets compared to the maturity of their liabilitieshigh term-transformation risk); To overcome the asymmetry of information in the banking system (i.e.; the bank knows more about the riskiness of its activities than its depositors); To protect small depositors; To facilitate banks orderly exit. 9
The Pros and Cons Cons Moral hazard: depositors have less interest in monitoring banks and banks have more incentives to increase their risks. Weaker market discipline. Generous deposit insurance might have negative effects on bank stability. Pros Create a safety net to prevent bank panics. Protect the smaller, less informed, depositors. 10
Size of the Fund US (200): 8,571 banks with $6.5 trillion in total assets and $2.5 trillion of insured deposits (38.5%) were contributing to the FDIC Insurance Fund, which at the time had accumulated $32 billion to cover this exposure. Was that enough? Which criteria should be used to answer that question? 11
Risk-Based Premium System The Deposit Insurance Fund is like an insurance company, with a portfolio of contingent credit exposures to insured banks. However, present approaches (flat premium schedule) set the desired reserve ratio as a fix percentage independent of the fund s actual loss profile. One innovative approach is to estimate a cumulative loss distribution and calculate potential losses against the reserves of the insurance fund (i.e., linking the desired level of capitalization with the desired credit rating). 12
Measuring Risk:Definitions Probability of default (PD i ):the probability that the counterparty (i) will fail to service its obligations Frequency Distribution of losses (number of loss events per year); Expected Loss (EL): mean of the loss distribution; Unexpected Loss( UL) : standard deviation of the loss distribution; Loss Given Default: the extent of the loss incurred in the event the counterparty defaults (% of Insured Deposits X) Severity Distribution (S, value of a loss event); Default Correlations: the degree to which the default risk of the counterparties are correlated. 13
Measuring Risk: Formulas ELi = PDi. Xi. Si Because default is a Bernoulli random variable, its standard deviation is PDi ( 1 PDi ), and if we assume no correlation between PD, S and X, then: UL i = 2 2 2 2 2 ( PDi PDi ) µ s X i + PDiX i σ s i i Where Si ~ f (µ s, s s ) and if s s = 0 then simplify. 14
Measuring Risk:Conclusion The exposure to individual banks can be added to get a cumulative loss distribution, reflecting the expected loss of individual banks, the size of individual exposures and the correlation of losses in the portfolio. The distribution will be skewed with lumpiness reflecting the contribution of large banks. The risk at the portfolio level then will be a weighted average of Elp= S EL i. The ULp is more complex since it must consider the correlation between individual losses r ij. 15
Probability of Default Three main approaches to estimating default frequencies: Historical default rate (for the FDIC the average default rate was 0.26% of assets per year between 1934-2000, see graph 1); Credit Scoring Models; Risk Ratings (S&P) --> PD 16
FDIC: Historical Default Rate 17
Severity (Loss given default) Approaches: Fixed or stochastic FDIC losses between 1985-1988 were 30% of insured assets, 1/3 of this were expenses (administrative + legal costs) and 2/3 bad assets. Pay-off to depositors of failed banks (less than 1/4 of cases); Purchase and assumption transactions. 18
Pricing: Insurance Fees Uniform fees Could be de-stabilizing Risk-based pricing Expected loss penalizes riskier banks but also smaller ones. Unexpected loss contribution based pricing penalizes larger banks. Ex-ante and Ex-post pricing; Ex-post rebates. Pro-cyclicality Designated Reserve Ratio drops when banks are weak, while the fund requires higher premiums when banks can least afford them. Fairness. 19
FDIC Pricing: Insurance Fees US: average 23 basis points, with a target level of reserves under the FDIC Improvement Act (FIDICIA) of 1.25% of insured deposits ( Designated Reserve Ratio ), plus a US$30 billion line of credit from the Treasury. After 1999, 97% of insured deposits had a de facto zero fee and the remaining 3% was differentiated by risk in 5 buckets with fees going from 3 to 27 bps (minimal risk differentiation for 8,000 insured banks with large differences in risk profiles and size). 20
Risk-based Pricing At a minimum premiums should cover expected losses: Making the fund self-financing through time; Relieving moral hazard; However,leads to under-pricing of very large exposures. To correct contributory risk affecting loss distribution should be included (Unexpected Loss Contribution). P i = El i + h ULC i 21
Risk-Sharing Splitting of loss-distribution in to two zones (see graph): Zone A: smaller losses cover by reserves; Zone B: catastrophic losses cover by loss reinsurance This structure mirrors the loss distribution for banks: Losses are covered by the bank shareholders up to the capitalization level; Beyond that, losses are borne by the deposit insurance fund and uninsured creditors. Risks are held by: government, banks themselves (mutual insurance), private capital or reinsurance market. 22
Risk-sharing: Zone A and B 23
Government System Mandatory Government assumes both parts of the risk distribution: Zone A losses -->Reserve Fund Zone B losses --> Treasury Deposit Premium = Expected loss <pricing by private sector (public good). Death spiral effect : Deterrence effect of insurance premiums might be insufficient if risk-taking is U- shaped (does not deter well capitalized banks or severely under-capitalized banks ==> need to complement it with other tools (PCA). 24
Private System Losses to be shared between banks and the capital and reinsurance market. Banks mutually insured losses in Zone A but reinsure or transfer Zone B losses. Practical problem: Fund s reserves well below insured deposits of largest bank. If so solvency standard difficult to reach. Higher price than in the closed government system. Large banks will be charged proportionately more because they impose a much greater need to hold incremental economic capital. 25
Private system (cont.) Cyclical behavior: during expansion system accumulates reserves beyond target solvency standard. If they result from: risks in Zone A --> rebates to banks; risks in Zone B --> profits to reinsurers. When reserves fall below the solvency standard there will be a need to recapitalize the fund. This is problematic since additional capital will be required at the trough of the business cycle. Although in theory a private system might lead to efficient pricing and correct incentives, in practice it might be unworkable (size of insured deposits vs. size of K and insurance markets). 26
Hybrid Deposit Insurance System Banks might mutually insure Zone A losses, while Government reinsures Zone B losses. The risk sharing determines how the risks are split. This leads to a dual pricing system, but government should chage banks for the expected loss for the excess of loss reinsurance. The latter would be very small if government insures extreme catastrophe losses. The price for insuring small banks in Zone A will depend on the sharing point. Expected losses plus economic charge for loss volatility up to the risk sharing point. If Zone A is small, prices will be close to expected losses. 27
C. The Mexican case Severe banking crisis (December, 1994); Universal deposit coverage to prevent bank runs (blanket guarantee including inter-bank deposits); Shock Denial Least cash but not least cost solution (FOBAPROA bonds) Creation of IPAB (1998) Towards resolution of banking problems Recapitalizations privatizations, liquidations and sale of NPLs. Cost of the crisis about 20% of GDP. Transitioning to a limited-coverage deposit insurance system. 28
D. Conclusions The risk management problem faced by a deposit insurance fund is directly related to the riskiness of the insured individual banks in the portfolio. Modern risk analysis theory should be used to estimate the cumulative loss distribution. Loss distributions should be broken down into two zones: Zone A losses covered by reserves (funded or collable) and Zone B excess losses covered by reinsurance. It must be decided who bears the risk in each zone of the loss distribution and how does the partition point influence pricing. Heterogeneity of banks complicates matters. 29
Conclusions (cont.) Arguably, the most practical and lowest cost solution is for the government to own both parts of the loss distribution. This can be viewed as a mandatory insurance contract between the government and the banks. Pricing should be risk-based on expected losses. This greatly mitigates banks moral hazard and ensures self financing over time. Countries with explicit deposit insurance are more attractive to international non-bank depositors, as well as those with coinsurance, low premiums and private managed systems. 30
Conclusions (cont.) Differential deposit insurance in each country offers the possibility of international regulatory competition. The EU Directive on deposit insurance imposes minimum standards but it is silent on the level of the premium. Unanswered questions: Cost to taxpayers for providing insurance provision. Only as a backstop providing catastrophic insurance?. How does this affect the probability of systemic risk?. 31
Bibliography Deposit Insurance and Risk Management of the U.S. Banking System: How Much?, How safe?, Who Pays?, by A. Kuritzkes, T. Schuermann and S. Weiner, The Wharton School, Financial Institutions Center, U. of Pennsylvania, 02/02-B, April 29, 2002. Guidance for Developing Effective Deposit Insurance Systems, Financial Stability Forum, September, 2001. Deposit Insurance Around the Globe: Where does it work?, E. Kane and A. Demirguc-Kunt, NBER, WP 8493, September, 2001. Deposit Insurance and International bank Deposits, H. Huizinga and G. Nicodeme, Economic Papers, Economic Commission, Directorate General for Economic and Financial Affairs, Number 164, February, 2002. 32