Deposit Insurance Before and After the Asian Financial Crisis

Introduction

In most economies banks play the major role among financial institutions in intermediating between savers and investors, in the operation of the payment system and the execution of monetary policy.2 The importance of banks in an economy, the potential for depositors to suffer losses when banks fail, and the need to mitigate "runs" and "contagion" risks, have lead many countries to establish financial system safety nets.3 These usually include prudential regulation and supervision, a lender of last resort facility4 and, increasingly, some form of deposit insurance. A deposit insurance system provides explicit -- but limited --protection for eligible depositors in the event of a bank failure. 5 Deposit insurance can be designed to fulfill a variety of goals. However, the most common objectives are to contribute to financial system stability and to protect smaller and less financially sophisticated depositors from loss.6 Without a credible deposit insurance system in place, the possibility exists that depositors might "run" by removing their deposits from a bank, and/or other banks, in response to difficulties at a single bank.7 Nevertheless, it is important to understand that the design of deposit insurance systems generally involve tradeoffs and the potential for introducing distortions into the financial system.8 The most notable being moral hazard - or the incentive for excessive risk taking by banks or those receiving the benefit of a guarantee of protection. For example, full coverage for all deposits would effect the greatest protection for depositors but at the same time present the greatest challenge for controlling moral hazard. At the other end of the spectrum, very low coverage levels -- that do not protect the majority of depositors in the system -- would not be effective at curtailing runs and protecting the savings of most depositors. Therefore designers of deposit insurance systems must choose coverage levels which provide adequate protection but which do not create excessive distortions such as moral hazard.9 Moreover, even a well-designed deposit insurance system needs to be supported externally by strong prudential regulation and supervision, an effective legal system, sound corporate governance and risk management in banks and appropriate accounting standards and disclosure regimes. Although deposit insurance is effective at protecting depositors and contributing to stability in most situations, it cannot by itself deal with a systemic financial system crisis.10 Systemic crises require the combined efforts of all safety net participants to effectively deal with them. Deposit insurance systems are most effective at dealing with single failures or a wave of small failures.download