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O C C A S I O N A L   P A P E R       197       Deposit Insurance Actual and Good Practices Gillian G.H. Garcia ©2000 International Monetary Fund January 2000 Contents Preface   I    Overview   II    Good Practices for Deposit Insurance Objectives Infrastructure Avoiding Moral Hazard Reducing Adverse Selection Minimizing Agency Problems Promoting Credibility Ensuring Financial Integrity A Summary of IMF Advice   III    A Survey of Deposit Insurance Practices Year of Origin of Limited Deposit Insurance Systems The Deposit Insurance Agency: Role and Responsibilities Membership Funding the Deposit Insurance System Deposit Coverage Governance Trends and Convergence to Good Practice   IV    On Instituting and Removing a Full "Blanket" Guarantee Indications of Systemic Instability Should a Deposit Insurance System Be Introduced in a Time    of Crisis? Allocating the Losses Caused by Bank Failures Should a Full Guarantee Be Provided? Principles to Follow When Offering a Full Guarantee On Removing a Global Guarantee   V    Summary and Conclusions   Bibliography   Statistical Appendix   Text Tables II 1.   Good Practices for Deposit Insurance III 2.   Countries with Explicit, Limited Deposit Insurance Systems     3.   Characteristics of Deposit Insurance Systems by Continent in 1995 and 2000 IV 4.   Response to Selected Systemic Crises     5.   Good Practices for Blanket Coverage in a Systemic Crisis     6.   Length of Full Guarantees   Figures II 1.   Ratios of Deposit Coverage to per capita GDP in Selected Countries, 2000 III 2.   Decade of Origination of Explicit Deposit Insurance Systems     3.   Insurance Fund Targets and Actual Levels Attained     4.   Premiums on Total Deposits, Insurable Deposits, Covered Deposits     5.   Deposit Coverage by Continent     6.   Percentage of the Number of Depositors Covered     7.   Percentage of the Value of Deposits Covered     8.   In Practice: Exclusions in the Year 2000   Boxes II 1.   Exclusions from Deposit Insurance Coverage     2.   Offsetting Loans Against Deposits   Statistical Tables   A1.   Depositor Protection Schemes Explicitly Defined: Membership and Nature of the Deposit Insurance System   A2.   Membership in Explicit Limited Deposit Insurance Systems     A3.   Private and Official Funding for Explicit Limited Deposit Insurance Systems     A4.   Building the Fund in an Explicit Limited Deposit Insurance System     A5.   Deposit Coverage in Explicit Limited Deposit Insurance Systems     A6.   Types of Deposit Covered and Excluded in Countries with Limited Explicit Deposit Insurance Systems     A7.   Effective Coverage in Selected Countries     A8.   Administering the Deposit Insurance System

I.  Overview In most countries, banks are the most important financial institutions for intermediating between savers and borrowers, assessing risks, executing monetary policy, and providing payment services. At the same time, the configuration of their portfolios makes them especially vulnerable to illiquidity and insolvency. In particular, by law, bank deposits have to be repaid at par; in addition, banks are highly leveraged and often maintain liquid assets to meet withdrawals only in normal times. In light of this vulnerability, government officials realize that the demise of one bank, if handled poorly, can spill over to others, creating negative externalities and causing a more general problem for other banks in the system. For these reasons, many governments provide a safety net for banks that generally includes deposit protection and lender-of-last-resort facilities, in addition to a system of bank regulation and supervision. Recognizing that financial stability is a public good with regional, and even global, implications (see Wyplosz, 1999), the international community is showing an interest in deposit protection. Although for many years the IMF and other international financial institutions have responded to inquiries from member countries concerning deposit insurance, their interest in the subject has intensified recently. Aided by the IMF's advantage of near universal membership (currently 182 countries), Kyei (1995) conducted a survey of both implicit and explicit systems of deposit insurance that were in existence in the early 1990s. Lindgren and Garcia (1996) surveyed explicit systems and detailed good practices for deposit insurance systems, while Garcia (1997b) and Folkerts-Landau and Lindgren (1998) summarized them. The World Bank's research includes that of Talley and Mas (1990) and recent papers by Demirguc-Kunt and Detragiache (1998 and 2000), Demirguc-Kunt and Huizinga (1999), and Honohan and Klingebiel (2000). The Financial Stability Forum has focused on deposit insurance in an effort to build an international consensus on best practices to discourage financial crises. A country faces six choices regarding deposit protection: (1) an explicit denial of protection, as in New Zealand; (2) legal priority for the claims of depositors over other claimants during the liquidation of a failed bank, as in Hong Kong SAR, instead of a deposit guarantee; (3) ambiguity regarding coverage; (4) an implicit guarantee, as found in 55 countries by Kyei in 1995; (5) explicit limited coverage—in this paper in 67 countries; and (6) a full explicit guarantee, as exists currently in nine countries. Choosing the first or second option is legitimate, but rare. The sixth possibility is generally reserved for periods of severe and systemic crisis. This paper explores options five and six. Much of the conceptual work on deposit protection has focused on the disadvantages of adopting explicit protection, whether limited or comprehensive. But these disadvantages may not be inevitable. Consequently, Section II of this paper explores ways to obtain the benefits of deposit insurance that so many countries seek while avoiding the well-explored pitfalls—moral hazard, adverse selection, and agency problems.1 In doing so it presents a set of good practices for explicit limited deposit protection. It does so in the belief that explicit limited coverage, if well designed, is preferable to ambiguity and implicit coverage and that it can complement legal priority. Section III describes the actual configuration of 67 explicit, limited systems of deposit insurance known to be in operation in the year 2000. It will conclude with an assessment of recent movements toward good practice. Section IV shifts to a consideration of whether and when to institute full or "blanket" coverage, and when and how to remove it. Section V summarizes and concludes. 1Moral hazard occurs when protection causes the beneficiaries of insurance (in the case of deposit insurance, this means depositors, bank owners, managers and supervisors, and even politicians) to be careless in their approach to bank soundness. Adverse selection occurs when only the worst risks seek to take advantage of protection, resulting in a financially nonviable system. Agency problems occur when the agent does not execute the desires/commands of his/her principal. In deposit insurance, the problem occurs principally when supervisors and regulators put the interests of the industry they regulate above those of the general population ("regulatory capture") and when politicians interfere in the supervisor's performance of his/her public responsibilities, often at the taxpayer's expense.