Designing Deposit Insurance

This document examines the target and design attributes of a deposit insurance product and the Latin American experience with the same. It considers deposit insurance schemes as an integral part of the entire gamut of financial safety nets that include appropriate regulatory framework, a central bank to provide liquidity and a favorable market environment.

The first part of the paper outlines the objective of the product which is to protect small and other depositors in the event of a bank becoming insolvent, recommending the following design strategies:

• To avoid moral hazard:
  • Provision for explicit deposit insurance with unambiguous rules;
  • Low coverage limited to deposits of individuals;
  • Maximum limit of coverage against the depositor and not the type of deposit account;
  • Higher quantity of the deposit accounts covered as compared to the value of the deposits covered;
  • Co-insurance.
• To avoid adverse selection:
  • Compulsory membership in the scheme;
  • Correct risk pricing.
• To avoid agency risk:
  • Having an independent deposit insurance providing agency.

The second part of the document discusses the following broad elements of product design with references to Latin American countries and how they compare with global systems:

• System formalization: majority of the countries in the region have explicit deposit insurance schemes and more than 90% were formed around the occurrence of a systemic crisis;
• Membership: compulsory participation;
• Coverage: all types of deposits insurable in majority of these countries;
• Premiums: 36.8% have premiums differing on the basis of risk as compared to 30% worldwide;
• Co-insurance: an established element in the explicit deposit insurance scheme;
• Administration: majority of the schemes are administered by public entities;
• Funding: the sources are mixed, private and public funding.

The paper concludes that deposit insurance can only protect the interests of depositors in the case of single institutions faltering and thus prevent the risk from becoming systemic and not essentially in the case of a larger systemic failure.