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General Overview about Deposit Guarantee System
The banking system is considered as the channel through which money is transferred.
As such it highlights the economic activity of nations.
Deposit guarantee schemes are among the public policy frameworks devised to protect depositors.
Deposit Guarantee Methodology:
Deposit insurance is a public policy issue that plays a central role in maintaining economic and financial stability. In its simplest form, deposit insurance is designed to protect depositors in the event that monetary authorities decide to liquidate a bank. However, the operation of deposit insurance systems is more complex than this basic concept.
There are a number of principles and foundations upon which deposit insurance systems are established. These principles define the public policy framework and the methodologies through which deposit insurance systems carry out their duties and responsibilities.
Different configurations can be adopted to suit the characteristics of each country’s economic environment and banking system.
The main principles include:
- Mandates and Powers
- Coverage
- Funding
- Calculation of Contributions
Mandates and Power:
The mandates and powers of deposit insurance schemes range from a pay box to reimburse depositors to a system with wide authorities that might include monitoring risk, entry and exit control, inspection of banks files or to assume bank administration or even to decide up on bank liquidation.
Insurance Coverage:
Coverage is defined in terms of scope and level. Scope of coverage refers to the eligibility of deposits to coverage (i.e., types of deposits to be covered) whereas level of coverage indicates coverage limits.
There are three coverage limits:
Blanket Coverage
blanket coverage provides full and general protection to depositors and creditors and is usually implemented during financial crises that might undermine the nations payments system. Blanket coverage aims to reinforce the depositors and the general public confidence in banking system. Meanwhile, it provides enough time to regulators to implement strategic decisions. Funding blanket coverage is over and above the ability of deposit insurance system, as such monetary authorities undertake financing blanket coverage.
Limited Coverage
Limited coverage protects depositors up to a specified maximum coverage limit. It is considered the most appropriate approach because it primarily protects small depositors, helps prevent bank runs, and maintains market discipline by exposing large depositors to potential losses.
Although deposit insurance literature identifies three types of coverage systems, in practice there is no deposit insurance system in the world that provides either full coverage or blanket coverage. Instead, limited coverage is the predominant model adopted by the majority of deposit insurance systems worldwide.
The appropriate level of coverage depends on public policy objectives. If the objective is to maintain banking stability, a higher maximum coverage limit may be established, while still preserving the role of large depositors in exercising market discipline. Conversely, if the objective is to protect small depositors and minimize moral hazard, a lower maximum coverage limit may be adopted.
In most cases, coverage levels are benchmarked by comparing the coverage limit to the Gross Domestic Product (GDP) per capita.
التغطية الكاملة Full Coverage
full coverage protects depositors by 100% and hence prevents bank runs. Full coverage minimizes depositors motive to withdraw their deposits from insolvent banks. It also enables banks to successfully pass the crises. Moreover,
it facilitates regulators intervention.
Full coverage is the preferred option if stability is the goal. However, it undermines market discipline and increases moral hazard. Furthermore, it does not prevent bank runs of insolvent banks due to temporary liquidity problems and freezing of deposits.
Most deposit insurance schemes do not cover the following deposits:
- Foreign currency deposits in local banks
- Inter-bank deposits
- Local currency deposits in foreign banks
- Deposits of members of board of directors and general managers and their spouses and children, and Deposits of bank’s Auditors
Funding:
To meet their obligations towards depositors, deposit insurance schemes need sufficient funds. these resources are used to cover insured deposits in the event of bank liquidation as well as to cover their administrative expenses.
Funding Methods
There are three methods of funding deposit insurance systems:
Annual Contributions (Ex-Ante Funding): Contributions paid by member banks before a bank failure occurs.
Ex-Post Funding: Contributions collected from member banks after the liquidation decision has been taken by the regulatory authorities.
Hybrid Funding: A combination of both ex-ante and ex-post funding methods.
Each funding method has its own advantages and disadvantages.
The annual contribution (ex-ante) system is similar to commercial insurance, where premiums are collected before a default occurs. In contrast, under the ex-post system, member banks pay their contributions only after a bank has been liquidated.
Ex-ante funding provides greater safety and credibility, as the collected resources are invested to build a target fund that can be used to satisfy depositors’ claims in the event of bank liquidation.
It is worth mentioning that approximately 80% of deposit insurance systems worldwide adopt ex-ante funding. This approach spreads the cost over time, unlike the ex-post system, which requires member banks to provide contributions at the same time following a bank failure. Moreover, ex-ante funding ensures that all member banks contribute equally, including institutions that may later become insolvent.
Calculation of contributions:
Two methods are available for calculating annual contributions: Flat-Rate Premiums and Risk-Based Premiums.
Flat-Rate Premiums
Under the flat-rate method, a fixed percentage of demand deposits, savings deposits, and investment deposits is paid annually by member banks to the deposit insurance scheme at the beginning of the fiscal year. All banks pay the same contribution rate, with the only difference being the size of their deposits.
One of the main drawbacks of this method is that it treats high-risk banks and banks with sound risk management equally.
Risk-Based Premiums
The risk-based premium method determines the contribution of each bank according to its level of risk. However, this method requires complex procedures for assessing and calculating the appropriate premium and may impose additional burdens on higher-risk banks.
Risk-based premiums generally require credit rating assessments from international rating agencies such as Standard & Poor’s, Moody’s, and Fitch. However, these agencies rely significantly on interest rates as a key assessment mechanism, which is not compatible with the principles of Islamic banking.
Furthermore, the credibility of some credit rating agencies was questioned following the global financial crisis. In addition, the risk-based premium approach may conflict with the Takaful principle, which represents a fundamental foundation of Islamic banking and Islamic deposit insurance.