Richmond Atuahene’s thoughts…Deposit protection corporation and its legal and regulatory framework: Ghana’s experience (part 4)

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In 1933, the Glass-Steagall Act established the US Federal Deposit Insurance Corporation to insure deposits of commercial banks. India, the Philippines and Sri Lanka all in Asia continent established their schemes in 1961, 1963 and 1987 respectively. In the Continental Europe, the German scheme which is administered by private institutions was established in 1998 while UK established deposit compensatory fund in 1979. Kenya, Nigeria, Tanzania and Uganda all in Africa established their schemes in 1985, 1989, 1994 and 1997 respectively.

Theoretical Framework

The study is anchored on the deposit insurance theory. The deposit insurance theory was postulated by Flannery (1989) but was later developed by Cham, Greenbaum and Thakor (1992). According to the theory, banks are viewed as portfolio of risky claims. As insured banks increase their risk of failure without limit, there is an expected value transfer of wealth from government, deposit insurance corporation to bank owners. Regulators are concerned about bank’s soundness, particularly with respect to solvency or the probability of bank failure. Therefore, regulation of bank risk is necessary to reduce the expected losses incurred by the deposit insurance corporation. Deposit solicited from customers are not dependable and reliable as the bank capital requirement. It cannot be used for long term planning. However, more deposit means banks can grant more loans and will not obviate the need for excessive capital. When bank loans and advances are given out to customers without proper due process, it might affect capital and liquidity position of a bank in the long term.

Nolte and Rawlins (2017) posited that for deposit insurance scheme be successful five preconditions have to be fulfilled which includes (a) a stable macroeconomic environment; (b) a sound and healthy banking system; (c) strong prudential regulation and supervision; (d) an effective bank resolution framework; and (e) a well-developed legal framework with efficient court systems and procedures along with a strong accounting and disclosure regime. In fact, introducing a scheme when these preconditions are not fully met could create a huge liability when improperly supervised banks or specialised deposit taking institutions fail. Additionally, in the absence of effective bank resolution tools, poor enforcement can trigger the need for back up funding from the government. This scenario could threaten overall financial stability, destroy tax payer funds and hamper economic development (Nolte & Rawlins, 2017).

Empirical Literature

There are many empirical studies in literature, examining how and to what extent deposit insurance system affects banking system. Davis and Obasi (2009) examined their studies the relation of deposit insurance with risk level of banking activities. It is found that deposit insurance doesn’t affect bank liquidity and capital sufficiency but it affects active qualities, as a result of the study. Dermirguc-Kunt, Karacaovali, and Laeven (2005) pointed out that every country has concealed deposit insurance due to the fact governments have great banking problems in their works. In the study, all deposit insurance data from 1960- 2003. According to deposit insurance database in the World Bank study by Dermirguc-Kunt, Kane and Laeven (2014), the number of open deposit insurance applying countries increased from 112 to 189 entered into open deposit insurance application with 2013. This proportion has been gradually increasing after 2007-2009 global financial crisis.

Cecchetti and Kruase (2005) examining the relation of capital markets with deposit insurance system, found that countries, having extensive deposit insurance scheme, have smaller capital market and less public companies, using data of 49 countries in their studies. Chernykh and Cole (2011) studied how Russian deposit insurance affects banking system, they found that deposit proportion of national and small scaled banks within the context of deposit system, are higher than deposit proportion of other banks out of this context in the study of Fueda and Konishi (2007) in which they used the data of Japanese banking system 1990-2005, it is stated that depositor’s discipline is the most important factor in full covered deposit insurance, rather than limited deposit insurance system. Chu (2011) found that low deposit insurance extent is more effective than high or unlimited deposit insurance extent on supplying bank stability, examining bank data of 52 countries between 1996-2007 in his study.

In addition to this, it is claimed that high deposit insurance extent destroys market discipline and leads to moral trouble, and the higher deposit insurance is offered, the severer banking crisis is met. Muslumov (2005) analysed the effect of full covered deposit insurance system, enacted in 1994, on financial performance of Turkish commercial banks, using experimental design approach in his study. According to results of analysis; it is found that full covered deposit insurance system destroys encouragement structure of banks, prevents proper working of market discipline mechanism and leads to over risk taking of banks.

Despite its increased favour among policy makers, the desirability of deposit insurance remains a matter of some controversy among economists. In the classic work of Diamond and Dybvig (1983), deposit insurance (financed through money creation) is an optimal policy in a model where bank stability is threatened by self-fulfilling depositor runs. If runs result from imperfect information on the part of some depositors, suspensions can prevent runs, but at the cost of leaving some depositors in need of liquidity in some states of the world (Chari and Jagannathan (1988)). As pointed out by Bhattacharya et al. (1998), in this class of model deposit insurance (financed through taxation) is better than suspensions provided the distortionary effects of taxation are small.

In Allen and Gale (1998) runs result from a deterioration in bank asset quality, and the optimal policy is for the Central Bank to extend liquidity support to the banking sector through a loan.3 Whether or not deposit insurance is the best policy to prevent depositor runs, all authors acknowledge that it is a source of moral hazard: as their ability to attract deposits no longer reflects the risk of their asset portfolio, banks are encouraged to finance high-risk, high-return projects. As a result, deposit insurance may lead to more bank failures and, if banks take on risks that are correlated, systemic banking crises may become more frequent. The U.S. Savings & Loan crisis of the 1980s has been widely attributed to the moral hazard created by a combination of generous deposit insurance, financial liberalization, and regulatory failure (see, for instance, Kane (1989)). Thus, according to economic theory, while deposit insurance may increase bank stability by reducing self-fulfilling or information-driven depositor runs, it may decrease bank stability by encouraging risk-taking on the part of banks.

According the Demirguc-Kunt and Kane (2005), a reliable deposit insurance scheme adds to financial stability by making bank runs less likely. On the other hand, deposit insurance can cause excess risk- taking and threaten bank stability in the long run. This can be prevented if capital positions and risk- taking of insured institutions are vigilantly managed.   Demirguc- Kunt and Detragiache (2002) used the World Bank’s new cross- country database to study the link between financial crises and deposit insurance. Their results indicated that the countries with the highest coverage limits in the sample (61 countries) are five times more fragile than the countries that impose the lowest coverage limits (less than per capita GDP). Also, it was found that banking crises were more likely, where a scheme was administered by government officials rather than jointly or in the private sector. Also, it was found that deposit insurance diminishes banking stability in countries that have poorly developed environments.

Gropp and Vesala (2004) tested the relation of deposit insurance with bank values, debt followings and taken risks of European banks. The study found that open deposit insurance application may significantly decrease the risks taken by banks. Maysami & Sakellariou (2008) examined interaction of open deposit insurance with banking crisis, and they found that banking crisis decreased in countries, applying this system. Quintanilla, Tellez and Wolfskill (2011) examined fully changed deposit insurance system and risks in Mexico which experienced a severe crisis in 1994, they found that deposit insurance funds worked more healthily when banks take lower risks.

 

DESIGN FEATURES OF DEPOSIT INSURANCE SCHEME

An effective deposit insurance scheme has many features, including public policy, aligned mandates and powers, appropriate coverage, adequate funding, efficient resolution and reimbursement, governance structure, transparency, accountability, and credible image. If insurance scheme is poorly designed, it may increase risks, notably moral hazard. Moral hazard refers to the incentive for excessive risk-taking by banks and other creditors are protected, or believe they are protected, from losses or when they believe that a bank will not be allowed to fail. In these cases, depositors have less incentive to access the necessary information to monitor banks. As a result, in the absence of regulatory or other restraints, weak banks can attract deposits for high risk ventures at a lower cost than would otherwise be the case. However, the best scheme will not achieve its public policy objective if stakeholders are unaware of its existence or unclear about the terms and conditions of coverage.

Public Policy Objective of Deposit Insurance Scheme

The main policy objective of deposit insurance scheme for most countries is to protect less financially sophisticated depositors in the event of a bank failure, thereby contributing to customer protection and enhancement of the stability of the country’s financial system. By protecting the covered deposits in all banks, the DIS can also contribute to the development of a less concentrated banking sector and support financial inclusion and transformation of the sector.

Deposit Insurance Scheme Mandates and Powers

A mandate is a set of official instructions or statement of purpose. There is no single mandate or set of mandate suitable for all deposit insurers. The existing deposit insurance scheme have mandates ranging from narrow, so called Pay box system, to those with broader powers and mandates such as Pay Box Plus, Risk minimization system and with a variety of combination in between.

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