core principles for effective deposit insurance...

David C. Parker

International Monetary Fund Monetary and Capital Markets Department

Core Principles for Effective Deposit Insurance Systems

-Overview and Methodology-

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Mandates & Missions

Protect (small) depositors

Contribute to financial stability

Preserve confidence in the banking system

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Mandates & Missions (cont…)

Also:• Promote competition• Promote economic development• Limit moral hazard• Promote market discipline

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Key Assumptions or Prerequisites

Coordination, communication, cooperation, and information sharing among all safety-net players.

Ministry of Finance

Central Bank

Deposit Insurance Organization

Bank Supervisor/ Regulator

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Effective Deposit Insurance Schemes

Preconditions

Core Principles

Assessment Methodology

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Preconditions

The advantages of an explicit, limited deposit insurance scheme can best be realized if certain conditions are in place before its introduction.

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Preconditions for Deposit Insurance

What do we mean by Preconditions?

Basically, the desirable circumstances necessary for a deposit insurance scheme’s (DIS) success

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Preconditions

Deposit insurance systems are most effective when certain external elements and preconditions are in place If actions are necessary to address any

deficiencies, then a deposit insurance system may be adopted or reformed

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Preconditions

Some basic preconditions:• Macroeconomic stability• Sound, market-based banking system• Strong prudential regulation and supervision• Well-developed, proper legal framework• Strong governance, accounting and

disclosure regimes

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Preconditions

To be effective a deposit insurance system must be:• Consistent with both the county’s economic

and institutional settings• Aligned with the public-policy objectives

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Objectives

Protect small depositors Promote financial stability by making

prompt reimbursement to insured depositors in the event of a bank failure

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Macroeconomic Stability

Macroeconomic instability hampers the functioning of markets and can distort financial intermediation• (i.e.) It is more difficult for banks and their

clients to judge different types of risks in unstable times.

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The introduction or reform of a deposit insurance system on its own will not be sufficient to restore macroeconomic stability

Deposit insurance is not designed, nor can it be expected, to resolve a systemic crisis

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Authorities should analyze the conditions and factors affecting the banking system that may influence a deposit insurance system’s effectiveness before introduction

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Macroeconomic StabilityThese may include:

• The level of economic activity• Current monetary and fiscal policies Inflation• Housing and financial assets price • Financial markets’ condition

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Sound Banking System

Policy makers must assess whether the entire banking system is sound, not just one institution within the system

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Assessing the banking system’s health includes:• Detailed capital adequacy evaluation• Liquidity• Credit quality• Risk-management policies and practices• Extent of any other problems

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Assessing the banking system structure includes:• the number, type and characteristics of

deposit taking institutions• the extent of competition, concentration,

interconnectedness, and the ownership of institutions

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State dominated:• When state makes credit and investment

decisions, it would not be credible to claim it does not back its obligations

• Deposits are perceived as having full guarantee

• Coverage restrictions are not meaningful

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System concentration - few very large banks Would require substantial resources to

compensate insured depositors TBTF – inevitably need taxpayer support to

compensate insured depositors No DIS means: implicit, discretionary scheme

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Small bank failures, however, can potentially affect financial stability

Contagion can spread rapidly to other banks—even large banks

Deposit insurance can reduce incentives for depositors to run from small banks

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Foreign ownership – arguments against a DIS:• Foreign banks dominate the system• Foreign banks have impeccable

reputations• Foreign banks’ parents have capacity and

commitment to support the subsidiary

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Strong Prudential Regulation and Supervision

• Directly impacts a deposit insurance system’s effectiveness

• Only viable banks can operate and be deposit insurance members

• In compliance with the Basel Core Principles for Effective Banking Supervision

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The supervisory authority should: • Have an effective licensing or chartering

regime• Conduct regular and thorough examinations

of individual banks• Have a problem bank process that includes

early detection, timely intervention, and resolution

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Problem bank process should include early involvement of DIS: • DIS should participate in examinations of

CAMELS 3, 4 and 5 rated banks (regardless of mandate)

• DIS should be included in the resolution process, including enforcement actions and resolution strategies

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Effective Legal Framework

Should include a system of business laws including:• corporate, bankruptcy (particularly banking

bankruptcy), contract, creditor rights, consumer protection, anti-corruption/fraud and private property laws

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Highly desirable to have a special bank resolution regime (SRR)

At a minimum, the SRR provides for a level of judicial review such that the bank supervisor’s decisions cannot be reversed—any successful appeals limited to monetary damages

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Legal Framework Nexus with DIS Objectives

Promote financial stability by making prompt reimbursement to insured depositors in the event of a bank failure.

If DIS must wait to reimburse insured depositors while bankruptcy court appeal process runs its course, it’s impossible to meet this objective

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Legal Framework Nexus with DIS Objectives

With SRR (and with advance preparation), DIS can make insured depositor reimbursement virtually immediately—either directly or via a P&A transaction

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The banking and deposit insurance legislation must be compatible Trigger for insured depositor repayment must

be harmonized in banking and deposit insurance legislation Information exchange between the deposit

insurance system and the supervisor is legally established

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Banking laws and regulations are updated as necessary Bank supervision and DIS staff are legally

protected for actions taken in good faith. The deposit insurance system, or other relevant

authority, can take legal action against the management of a failing bank

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Sound Governance

Sound governance means: independence, accountability, transparency, disclosure, and integrity

Each safety-net participant is operationally independent and objectives are consistent

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Sound Governance

All safety-net participants should be provided with all the means necessary to fulfill their mandates

The safety-net framework should clearly define the decision-making body in a time of crisis

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Accounting and Disclosure

Should include comprehensive, well-defined and internationally accepted accounting principles Financial statements users must have

independent assurance that accounts:• provide an accurate view of the

company’s financial position• are prepared according to established

accounting principles

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Banks must publish financial statements periodically Banks must have an annual independent audit Investors and large depositors can use this

information to increase market discipline

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Other key elements:• Additional tools for bank supervisor and

DIS to evaluate individual banks’ health and banking systems as a whole

• Provides basis for accurate and timely insured deposit determination, necessary for prompt reimbursement

• Accurate data for risk-adjusted differential premium systems

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Review:

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Preconditions Summary

Basic preconditions:• Macroeconomic stability• Sound, market-based banking system• Strong prudential regulation and supervision• Well-developed, proper legal framework• Strong accounting and disclosure regime

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Core Principles

Outline:

Background Core Principles Assessment Methodology

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Background

The International Association of Deposit Insurers (IADI) developed a set of Core Principles for Effective Deposit Insurance Systems in February 2008.

Sources: FSF (2001), IADI research and guidance (2002-2009), APEC policy dialogue (2005) and consultation with BCBS and EFDI.

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Background

In July 2008 a working group comprised of Basel Committee on Bank Supervision (BCBS) and the Guidance Group of IADI representatives was formed to develop a set of joint Core Principles.

Were released by BCBS and IADI in June 2009

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Background

Core Principles objectives :• Enhance effectiveness of deposit insurance

systems worldwide• Be reflective of and adaptable to a broad

range of country circumstances, settings, and structures

• Utilize the practical experience of deposit insurers

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Background

The Principles were designed to be neutral with regard to different approaches to deposit insurance, so long as the overriding goals are achieved

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Core Principles Preconditions

Effective deposit insurance preconditions: An ongoing assessment of the economy and

banking system Sound governance of agencies comprising the

financial safety net Strong prudential regulation and supervision A well developed legal framework, governance,

accounting and disclosure regime

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Core Principles Preconditions

Preconditions may not be ideal and if this is the case, it is important to identify them. If actions are necessary, they can be taken

before, or in concert with, the adoption or reform of a DIS. Assessment of preconditions should rely as

much as possible on official IMF and World Bank documents (e.g. FSAPs)

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Core Principles

There are 18 Core Principles regarding:Policy issuesDesign featuresLegal issuesEffective bank resolution

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Assessment Methodology Framework

Compliant

All essential criteria are met without any deficiencies. Largely Compliant

Only minor shortcomings—authorities can achieve full compliance within a prescribed time frame. Materially Non-Compliant

Severe shortcomings which cannot be easily rectified. Non-Compliant

No substantive implementation of the principle. Not Applicable

Not relevant to the circumstance of the insurer.

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Principle 1 – Public-policy objectives

The two fundamental public-policy objectives are to:1. Protect small depositors2. Contribute to financial stability

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Principle #2 – Mitigating Moral Hazard

Moral hazard is inherent in insurance, and especially deposit insurance The deposit insurance system should contain

appropriate design features to help mitigate moral hazard

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Principle #3 - Mandate

A deposit insurer’s mandate must be clear and formally specified There must be consistency between public-policy

objectives and the powers and responsibilities given to the deposit insurer.

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Principle #4 - Powers

A deposit insurer should have all powers necessary to fulfill its mandate. Some of these powers include the ability to: Finance prompt insured depositor repaymentsEnter into contractsSet internal operating budgets and procedures,

andAccess timely and accurate information to ensure

that they can meet their obligations to depositors.

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Assessment Criteria Example: CP#4

Essential criteria 1. The powers(legal authority) and responsibilities of

the deposit insurance system are clearly defined and formally specified in the law or regulation (including approved self-regulation in the context of private or public deposit insurance systems).

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Essential criteria 2. Deposit insurer has all powers necessary to fulfil its

mandate. In particular, the deposit insurer can:(a) compel member banks to comply with their

obligations to the deposit insurer; (b) have the means to reimburse depositors(c) enter into contracts (i.e. agreements or

transactions to obtain goods, services, or insurance)

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2 (cont.)(d) set internal operating budgets and internal

procedures (e.g., human resources)(e) access timely and accurate information to meet

their obligations to depositors (f) share information with other safety-net

participants (g)engage in information sharing and coordination

agreements with deposit insurers in other jurisdictions

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Principle #5 - Governance

The deposit insurer should be operationally independent, transparent, accountable and insulated from undue political and industry influence.

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Principle #6 – Relationships

The deposit insurer and other financial system safety-net participants must have a framework for close coordination and information sharing on a routine basis. In particular the deposit insurer must have accurate

and timely information regarding problem banks. Information-sharing and coordination

arrangements should be formalized.

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Principle #7 – Cross-border issues

All relevant information should be exchanged between deposit insurers in different jurisdictions and between deposit insurers and other foreign safety-net participants when appropriate (with proper confidentiality arrangements, of course).

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Principle #8 - Membership

In order to avoid adverse selection, membership in the deposit insurance system must be compulsory for all financial institutions accepting deposits.

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Principle #9 - Coverage

Coverage has two components:1. Scope2. Level

Insurable deposit must be clearly defined in law, prudential regulations, or by-laws. The level of coverage should be limited but

credible and capable of being quickly determined.

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Principle #9 - Coverage

Coverage has two components:1. Scope2. Level

Insurable deposit must be clearly defined in law, prudential regulations, or by-laws. The level of coverage should be limited but

credible and capable of being quickly determined.

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Principle #10 –Blanket Guarantee Transition

Countries with blanket guarantees are encouraged to transition to a limited coverage deposit insurance system as rapidly as possible. Blanket guarantees can have a number of adverse

effects if retained too long (most notably, moral hazard). Policymakers should pay particular attention to

public attitudes and expectations during the transition period.

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Principle #11 - Funding

A deposit insurance system should have all necessary funding available to ensure the prompt reimbursement of depositors’ claims (including emergency back-up funding). Member banks must pay for deposit insurance (i.e.,

entrance fees, premiums), since they and their clients directly benefit from having an effective deposit insurance system.

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Principle #11 – Funding (cont.)

The criteria used in any risk-based premium system should be transparent to all participants. In addition, all necessary resources should be in place to administer the risk-adjusted differential premium system appropriately.

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Principle #12 – Public Awareness

An effective deposit insurance system will keep the public informed about all aspects (e.g., benefits and limitations) of the deposit insurance system.

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Principle #13 – Legal Protection

The deposit insurer’s board members and employees should be protected against lawsuits for their decisions and actions taken in “good faith” and in the normal course of their duties. In turn, board members and employees must abide by

proper codes of conduct (e.g., conflict-of-interest). Legal protection should be defined in legislation and

administrative procedures, and include coverage of legal costs for those indemnified.

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Principle #14 – Parties at fault

A deposit insurer, or other relevant authority, should have the power to seek legal redress—criminal and civil--against those parties at fault in a bank failure.

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Principle #15 – Early detection, timely intervention, and

resolution The deposit insurer should be part of a framework within

the financial safety net that provides for early detection, timely intervention, and resolution of troubled banks.

Problem banks should be so designated on the basis of well defined and transparent criteria by operationally independent supervisory authority which has the power to act.

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Principle #16 – Effective Resolution Processes

Effective failure-resolution processes should:• Facilitate the deposit insurer’s ability to meet

it’s primary obligation: prompt reimbursement to insured depositors.

• Minimize resolution costs and disruption of markets

• Maximize recoveries on assets• Reinforce discipline through legal actions in

cases of negligence or other wrongdoings

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Principle #16 – Effective Resolution Processes

There must be a flexible mechanism to help preserve critical banking functions (i.e., maintaining clearing and settlement activities)by facilitating transfer of a failed bank’s assets and liabilities (at a minimum, insured deposits). Specifically, a deposit insurer must be able to

use its funds to facilitate a P&A transaction.

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Principle #17 –Reimbursing depositors

When an insured event occurs, depositors should have a legal right to prompt reimbursement up to the coverage limit. The deposit insurer should inform the public of applicable coverage limits, along with when, where, and how payment will be made.

The deposit insurer must be involved early in the problem bank process and provided depositor information in advance in order to adequately prepare for prompt reimbursement.

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Principle #18 - Recoveries

The deposit insurer, as subrogee to insured deposits payment, should share the proceeds of recoveries from the estate of the failed bank. Failed bank asset management and disposition

should be guided by net present value principles.

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Collaborative process to develop an agreed upon “Assessment Methodology” with:

• Basel Committee on Bank Supervision• International Association of Deposit

Insurers• International Monetary Fund• European Forum of Deposit Insurers• World Bank and European Commission

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Drafting completed August, 2010 Following approval from the Executive Boards

of IADI, EFDI and the BCBS, the Methodology will undergo:• Full public consultation (September -

November) Field tests (September – October): Czech

Republic, India and Mexico

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Methodology to be approved by IADI, EFDI and BCBS and presented to the Financial Stability Board (FSB) – November/December 2010.

Expectation: Eventual incorporation into Financial Stability Board (FSB) Compendium of Key International Standards

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Objectives of Methodology

Identification of the nature and extent of any weaknesses in the deposit insurance system in compliance with the Principles

Benchmark systems against the Core Principles to judge how well the system meets its mandates.

Aid the deposit insurer and policymakers in making improvements to the deposit insurance system and financial safety net

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Use of Methodology

Methodology can be used in multiple contexts: i) IMF/World Bank assessments in the context of

the FSAPii) Peer reviews conducted, for example, by IADI

regional committeesiii) Self-assessment performed by the deposit

insureriv) Reviews conducted by private third parties

such as consulting firms

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Use of Methodology

Assessments will be conducted by suitably qualified persons

Assessments require cooperation of all relevant authorities

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Thank you

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