A deposit insurance system for the Netherlands Antilles: What do we need and what can we afford? BY:
Economic development in any country is highly dependent on a stable and sound financial system. A troubled bank would affect the confidence of the depositors, which can lead to bank run and occasionally to systemic bank failures. The financial crisis in 2008, which emanated from the U.S. real estate market, is having an enormous effect on the global economy. Not surprisingly that in this financial turbulence, the depositors wonder whether their savings are protected. The aim of a deposit insurance system is to sustain confidence in the banking system and to encourage financial stability.
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Introduction
organizations of banks), the minister of Finance will have to introduce a deposit insurance scheme.
A deposit insurance system alone is not sufficient to ensure financial safety. Next to the deposit insurance system, the financial safety net has the following components: a lender of last resort and prudential supervision and regulation. Without strong bank supervision, the central bank (as lender of last resort) and deposit insurance might end up giving financial assistance to insolvent banks, which could undermine the health of the financial system. Hence, a deposit insurance system is part of a well-designed financial system safety net. As of late, the global financial crisis has put the focus on the issue of deposit insurance in the Netherlands Antilles. Several institutions in the Netherlands Antilles have argued that domestic banks should establish a deposit insurance system for their depositors. The National Ordinance on the Supervision of Banks and Credit institution (“Landsverordening Toezicht Bank en Kredietwezen 1994”) gives guidelines to the set-up of deposit insurance (“deposito beschermingssysteem”). Some issues regarding the deposit insurance, such as the amount and categories of accounts covered by the insurance will be enforced in a separate law, a National Decree (“Landsbesluit”). The law states explicitly that if no consensus can be reached by the parties involved (in this case, the Central Bank and the representative
1.Deposit insurance systems 1.1 An overview The objective of deposit insurance is to stabilize the financial system in the event of bank failures by guaranteeing the deposits. This would discourage depositors to make a “run” on the troubled bank. Bank runs not only threaten troubled banks, but can affect healthy banks as well. Hence, deposit insurance can prevent panic from spreading through the entire financial system. The deposit insurance has the following advantages: 1. It provides security to depositors against bank failures. 2. It helps to stabilize the economy in period of financial crisis by avoiding large losses of wealth when financial institutions fail. The deposit insurance has the following disadvantages: 1. The moral hazard phenomena: It can create irresponsible behavior by banks or depositors, or both. Depositors can become less careful in selecting their banks, knowing that their savings are protected. As a result, this can encourage the financial institutions to go for riskier investments, knowing that bank runs
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LENNIE PAU & MIRIELA G.L. CAROLINA
are unlikely. Moral hazard can also affect supervisors, because they may not have sufficient information of their banking clients. Therefore, these supervisors may become less willing to demand unsound banks to take corrective actions (and supervisions may forbear). 2. Adverse selection: This happens if the deposit insurance is voluntary and the premiums charged are not risk-adjusted. This will cause the strongest banks to withdraw or remain outside the fund and only the weakest institutions will remain. 3. Principle-agent problems: The agent (deposit agency) pursues his own interests rather than those of the principal (the savers), who he is supposed to be representing. An example is the case when a deposit insurance agency is supposed to protect depositors, but may be unduly influenced by member institutions. The public must be able to hold the deposit insurer accountable for its actions. 4. It is frequently mentioned that the deposit insurance makes it easier to close failed banks.
1. The amount covered The amount covered is country specific. The main objective of the coverage limit is to protect the majority of the depositors and prevent bank runs without deregulation of the market discipline.
Many national deposit insurers are members of one or more international organization of deposits insurers. Two well-known organizations on international level are: 1. International Association of Deposit Insurance (IADI). 2. European Forum of Deposit Insurers (EFDI).
3. Per account or per depositor The insured coverage can be limited to per accounts or per depositors. In most countries, the amount covered is per depositor and per institution basis. A few countries cover on a per account basis. In a DIS that covers a maximum per account, any depositor can easily open numerous accounts with each account containing the maximum insured value. Thus, the system of a maximum insured amount per account will not reduce the moral hazard problem. Not surprisingly therefore, that many countries have introduced coverage limits per depositor.
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1.1.1 Deposit insurance system and the lender of last resort Although most central banks have the function of lender of last resort, there is a widespread notion that a central bank will provide short-term loans only to a solvent, but illiquid financial institution. Furthermore, in times of systemic banking crises, banks have a higher frequency of becoming insolvent and it is not realistic for the central bank to exercise its function as the lender of last resort. In a well-designed safety net, the deposit insurance will provide assistance to the troubled banks. In cases of severe bank runs, blanket guarantees3 were given. They served as a temporary assurance, while in meantime attempting to restructure the troubled banks.
1.3
Funding the guarantees
According to Garcia and Prast (2004), the three most important options in the implementation of an insurance scheme are: 1. Flat rate or risk-adjusted rate/assessment of deposit base. 2. Ex-post, ex-ante, or mixed funding. 3. The size of the fund.
1.3.1 Flat or risk adjusted rate?
1.2 Coverage of the fund
There are different deposit insurance systems; the variations are linked to funding and premium setting procedures. With a flat rate premium, all members are charged with a uniform rate. Meanwhile, with a riskadjusted rate premium, premiums differ by the level of risk of the member institutions. A risk-adjusted rate is feasible4 in an ex-ante funding system.
One of the main features in creating a deposit insurance system is to determine the maximum insurance coverage or the coverage level (limit). This is the maximum amount a depositor can claim from the deposit insurer when a bank fails. There are substantial differences between the insurance systems: 1. The amount covered. 2. Extension of the coverage. 3. Per account or per depositor.
The premiums charged could be assessed on one of the following bases: 1. The total deposits in the system. 2. The deposits eligible for insurance.
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2. Extension of the coverage Most DIS cover the accounts denominated in domestic currency. The coverage can be extended to foreign accounts. Covering of foreign currency accounts deposit is also country specific. In countries where foreign currency deposits are relatively large, the DIS will be most effective, when the foreign currency deposits are insured. In the case of countries with a pegged exchange rate, similar to the Netherlands Antilles, a coverage extension including U.S. dollar accounts will increase the credibility of the fund. Another example of extension of the coverage is a DIS covering joint account holders individually.
3. Eligible deposits within a coverage limit.
liquidity.
1.3.2 Ex-post, ex-ante or mixed funding?
1.3.3 The target size of the fund and the coverage limit
In general, three classes of deposit insurance schemes exist: 1. Financial institutions will divide the costs of the collapsed bank: het omslagstelstel or the expost funding. In this funding system, the amount of funding that needs to be collected takes place after bank failures. 2. A fund that reimburses the depositors when a bank collapses: het kapitaalstelsel or the exante funding. The resources are built up by periodic contributions of member institutions, which are paid out to depositors during bank failures. 3. A funding that has ex-post and ex-ante features (mixed funding).
Generally, the fund size target is set periodically based on government policies. Premiums are adjusted periodically depending whether the actual size of the fund is above or below its target size. Related to the target size of the fund is the coverage limit. The coverage limit or coverage level is the maximum amount that will be covered in case of bank failure. In most funding systems, policymakers choose to establish an (initial) coverage limit. Prior to selecting the initial coverage limit, policymakers must collect all the necessary information on the number of accounts and their size distribution. The coverage limit has to be consistent with the objectives of the DIS and thus is country specific. A coverage level has to maintain the depositor confidence. Not surprisingly, that in time of financial crises, coverage limits are temporally raised. Both the IMF and the IADI proposed rules of thumbs for the deposit coverage for the fund. A rough rule of thumb by the IMF: The deposit cerage of the fund should be about twice the country’s per capita Gross Domestic Product (GDP). Rule of thumb by the IADI: A deposit coverage that covers at least 80% of depositors and 20 – 40 % of total deposits is deemed as satisfactory.
An ex-post system has the following disadvantages: 1. The failed bank is not being penalized for its risky behavior. It is unfair, that the riskseeking bank provides no resources to compensate its depositors. 2. It does not give incentives to avoid risk. 3. Timing is important. It is argued that banks fail when the economy is weak.The other banks are usually under stress and may not be able to deal with extra costs 4. The time involved in reimbursing is extensive.
1.4 Case studies FDIC and CDIC The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships. 10 Membership is compulsory for every deposit-taking financial institution, so as to minimize the problem of banking instability associated with voluntary participation. The FDIC is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in the U.S. Treasury securities. The rate of premium that the FDIC charges is assessed on the risks the institutions pose to the fund. According to the rule adopted in November 2006, beginning in 2007, the FDIC has to place each institution in one of the four risk categories, which are based on two criteria, capital levels and supervisory ratings. Institutions are categorized in three groups in accordance with their risk-based capital ratio:
An ex-ante funding has the following advantages: 1. It ensures that a failed institution that has contributed to the fund will compensate its depositors. 2. Reduce cross-subsidy of weak institution by stronger peers. 3. A fund that charges risk-adjusted premiums will counteract adverse selection and moral hazard. 4. The fund can be seen as a macro-economic stabilizer. It is argued that banks fail when the economy is weak. 5. Public confidence is gained if a protection scheme is well funded. 6. Less pressure on the government funds. 7. Compensations are paid more quickly. By contrast, the ex-ante funding has the following disadvantages: 1. Managing the fund can involve high cost, depending on the occurrence of bank failures. In the case of a low bank failure rate, the management cost will be too high compared to the benefits. 2. The fund assets should be low-risk and of high
1. Well capitalized: 10% or higher. 2. Adequately capitalized: 8% or higher. 3. Undercapitalized: less than 8%. The supervisory group assignment is categorized into
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The U.S. with the FDIC is based on a mix between ex-ante and ex- post funding. The Netherlands’ deposit insurance scheme is based on het omslagstelsel, the expost funding. The advantage of an ex-post system is that this system can improve inter-bank monitoring; as each bank has the incentive to give timely warning signals of a member bank malfunctioning and avoid the cost associated with a member failed bank.
groups A, B, and C. The ranking is based on evaluations provided by the regulator:11
The functions of the CDIC were originally set out as follows:
1. Group A is financially sound institutions with only a few minor weaknesses. 2. Group B consists of institutions that demonstrate weaknesses which, if not corrected could result in significant deterioration of the institutions and increase risk of loss to the insurance fund. 3. Group C consists of institutions that pose a substantial probability of loss to the insurance fund unless effective corrective action is taken.
1. CDIC was authorized to acquire assets of a member institution, to grant and guarantee loans and advances, and to guarantee loans to or deposits with a member institution. 2. CDIC could act as receiver for a failed institution and pay depositors’ claims of up to CAD$20,000 per depositor by depositing cash or transferring this sum to another institution. 3. CDIC could collect an annual premium equal to at least CAD$500, or one-thirtieth of one per cent of the total amount of deposits, whichever was greater. After the establishment of the QDIB the following amendments were made by the CDIC: 1. To provide coverage for deposits outside Quebec accepted by institutions incorporated in Quebec. 2. To insure deposits in Quebec of institutions incorporated in other provinces, provided there was no other agreement with the latter. 3. To provide assistance to QDIB in case of a need for liquidity.
Within risk category I, the institutions with the least risk are charged by the minimum annual rate, 5 basis points, and those that pose the greatest risk a maximum of 7 basis points. The premiums are paid on the insured deposits.This base rate schedule allows the FDIC Board to adjust rates from one quarter to the next, provided that a single change in one quarter does not exceed 3 basis points. The FDIC has suggested increasing the current rates equally by seven basis points for the assessment in the first quarter of 2009. The FDIC has proposed new rules, as a result of the financial crisis. For new insured depository institutions in risk category I, the maximum rate will be applicable, effective on January 2010. These proposed rates are presented in Table 4. Since 1990, a DRR (designated reserve ratio), the funds’ target, was established and is currently 1.25% of the insured deposits. The premiums are adjusted depending if the reserve ratio was below or above the target. In 2007, the Deposit Insurance Fund balance was approximately $52.4 billion, which represented a reserve ratio of 1.22% of the insured deposits (approximately $4.29 trillion).
The CDIC charges its members a premium that is proportional to the insurable deposits. Institutions can forecast the premium owed, however, the premium may be lowered by a certain amount based on good behavior ratings or measures leading to sound financial health. Hence, this encourages the institutions to reduce costs by improving their behavior. By law the CDIC’s charges its members different premiums depending on the ratings, based on a number of criteria or factors. The members are classified into four different categories.
2. A deposit insurance scheme for the Netherlands Antilles A deposit insurance scheme of the Netherlands Antilles has to take into account the upcoming changes in the constitution. As the Netherlands Antilles cease to exist, the deposit insurance scheme is applicable to Curaçao and St. Maarten. A new deposit insurance scheme has to comply with the Core principles for effective deposit insurance system of the IADI. First, we analyze the regional DIS to gain insight in the functioning of these systems in our neighboring countries.
The Canadian Deposit Insurance Corporation (CDIC) is a federal Crown corporation formed by the Parliament. The federal deposit insurance system was introduced in Canada in 1967 partly to “reassure” worried depositors.The CDIC covers deposits of banks, trust companies, loan companies, and associations governed by the Cooperative Credit Associations Act. In Canada, there exist 2 deposit insurance systems. In 1968, Quebec established its own deposit insurance system (QDIB). Membership is compulsory.
2.1 A regional overview To ensure the depositors’ savings, some Caribbean countries recently established a DIS, with the exception of Puerto Rico, as it falls under the FDIC. Trinidad and Tobago (1986), Venezuela (1985), and Colombia (1985) have the oldest fund systems in the region. Except for Venezuela (Banco Latino) and the recent
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To determine the assessment rates the financial ratios method is used. This method uses weighted CAMELS component ratings and the following financial ratios: 1. The Tier 1 leverage ratio. 2. Loans past due 30-89 days/gross assets. 3. Nonperforming assets/gross assets. 4. Net loan charge-off/gross assets. 5. Net income before taxes/risk-weighted assets.
financial systems is necessary. Information sharing with other deposit insurers is important especially when supplementary coverage for foreign bank branches exist. Principles 8-10: Membership and coverage To avoid adverse selection, membership should be compulsory. The coverage of the insured deposit should be clearly defined by law. Coverage limits may need to be adjusted periodically (e.g., due to inflation) Principles 11-12: Funding Recent IADI research indicates that ex-ante funding has more advantages than disadvantages. Ex-ante funding is preferred, because: (1) It is more transparent with respect to collection of funds, (2) It has short delay in payouts to depositors following bank failures; and (3) It maintains public confidence in banks. In the ex-ante funding, the premiums can be flat-rate or on a risk-adjusted basis. Transparency is a requirement in a risk-adjusted premium environment. Principle 13: Public awareness The public should be informed about the benefits and limitations of the DIS. The characteristics of the DIS should be publicized on a regular basis. Principles 14-15: Selected legal issues Individuals working for deposit insurers and other financial system safety-net participant should be protected against lawsuit, while executing their mandates. On the other hand, they must be follow oaths of office, conflict-of-interest rules and codes of conduct. A depositor insurer should be provided with the power to investigate/litigate against those parties at fault of bank failure. Principles 16-18: Failure resolution There must be a framework that ensures for a prompt detection-action mechanism in case of a troubled bank. In case of failure, three resolutions exist: (1) Liquidation and reimbursement of depositors’ claims. (2) Purchase-and-assumption transactions (sales). (3) Open-bank financial assistance. In case of bank failure, the processes should also ensure that the depositors are reimbursed promptly and minimize the resolution costs and disruption of markets. A bridge-bank authority has to be established to help preserve important banking functions. Principles 19-20: Claims and recoveries The deposit insurer should be notified in advance of the bank closure, to be able to prepare the payment of the insured deposits. The depositor should be given the time frame of the reimbursement and whether any advance payment will be made. Principles 21: Moral hazard One disadvantage of a fund is the moral hazard problem. In order to mitigate this problem, a fund has to take the following into consideration: (1) Placing limits on the amounts insured; (2) Excluding certain categories of depositors from coverage;(3) Implementing a risk
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2.2 Rationale for the establishment of deposit insurance scheme in the Netherlands Antilles Many financial systems have instituted a deposit insurance scheme with the objective to limit the possibilities of contagious bank runs and to protect the funds of small and medium depositors. Although the Netherlands Antilles does not have a history of a bank crisis, being pro-active by introducing deposit insurance in relative normal times, is the key of effective planning. In order for the Netherlands Antilles to design a sound deposit insurance system, it should conform to the core principles for effective deposit insurance system as stated by the IADI.The core principles are as follows: Principles 1-2: Setting objectives and the external environment The public-policy objectives of the fund have to be addressed clearly. What is the motivation for establishing a DIS in the Netherlands Antilles? Furthermore, the economic conditions have to be assessed by compiling macroeconomic, financial indicators, legal framework. Also, the state of the banking system has to be assessed. Principles 3-4: Mandates and powers The mandates for the deposit insurers have to be set and have to be consistent with the stated objective. A deposit insurer should have all the powers to fulfill its mandate. Principle 5: Governance Operationally independent and accountable safety nets organizations with clear mandate and free from political influences are a must in this system. Principles 6-7: Relationships with other safety–net participants and cross-border issues A close coordination and information sharing among Footer notes
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CLICO Investment Bank (CIB) failure in Trinidad & Tobago, bank crises in the region have been rare. In the region, the following countries implemented a deposit insurance scheme; Bahamas, Barbados Jamaica, Puerto Rico, Trinidad & Tobago, Venezuela, Colombia, and the Dominican Republic. Most funding is on an ex-ante basis; 38% of the countries are based on risk-adjusted premiums and 50% explicitly stated using flat rates. In most countries, the coverage is limited to domestic currency only, with the exception of Jamaica, which covers all currencies. Also, the maximum amount insured varies considerably. Excluding Puerto Rico, the amount varies between $5,900 in Jamaica to $50,000 in the Bahamas. Another distinction is coverage per depositor or per account basis. The DIS of most of the countries (excluding the Dominican Republican, due to unavailable information) is per depositor basis. Jamaica and Trinidad & Tobago are insuring joint account holders, which make them the only countries in the Caribbean (excluding Puerto Rico) insuring joint account holders.
adjusted premium system; (4) Minimizing the risk of loss through early disclosure of troubled banks; and (5) Demonstrating a willingness to take legal action against directors for improper acts.
adequate funding. In accordance to the Core Principles, the deposit insurance corporation has to be an independent body that performs additional regulatory authority in the supervision of banks to guarantee compliance with bank solvency regulations. However, one can argue that due to our small scale, our limited resources have to be well allocated. Still, the concern of conflict of interest is a major drawback for the well functioning of the deposit insurance. We have to take into account our limited resources and simultaneously strive for an efficient-functioning deposit system. We suggest a more elaborate study on this particular topic to find whether an independent body is feasible in our situation. Transparency and coordination among the participants in the safety net play a crucial role to achieve an efficient system.
2.2.1 The size of the fund The funds’ target size and its funding will be the main challenge in the set-up of the system. The public-policy objective, the coverage limit, the extent of coverage, and the funds’ target size are topics that are interrelated. Hence, these components have to be in place, as to create an effective and credible fund. Although setting coverage levels are country specific, two international organizations have proposed rule of thumbs on the coverage level. Besides the coverage limit and its extension, we have to ask ourselves whether we can we afford the funds’ coverage levels that are proposed by the international organizations. Setting a coverage limit that is too low tends to be less effective in instilling confidence on the depositors. Hence, a low coverage limit runs the risk of undermining the credibility of the safety-net. Setting a high coverage limit can result in inadequate funding, which will ultimately result that bank failures will become a fiscal problem. Therefore, it is important to avoid inadequate funding. So far, we are fortunate that we do not have a history of any bank failures in the Netherlands Antilles. To introduce a deposit insurance system in the Netherlands Antilles will be a pro-active insurance mechanism that will provide a backup position to the depositor. It is common for many countries to contemplate adopting a deposit insurance system when confronted with bank failure. However, it is recommended and more beneficial to adopt a deposit insurance system in relative normal times in the banking system. The deposit insurance system has a preventive role by raising the confidence of depositors and reducing the possible bank runs. Also, it protects the small depositors in the event of bank failures that are small enough not to represent a systemic risk. The deposit insurance system can work effectively up to the moment where a risk of widespread collapse exists. A widespread collapse could become a fiscal problem. It is of utmost importance to have a well-designed deposit insurance system, because it can improve the incentives for good governance for banks. This includes planning on sound funding, which is crucial for the deposit insurance to be effective and credible. In addition, a deposit insurance system has to conform to the Core Principles, as proposed by the International Association of Deposit Insurers (IADI), which is the platform for most deposit insurance systems worldwide. The most effective system for the Netherlands Antilles would be an ex-ante, risk-adjusted, and compulsory system with
Lennie Pau
Miriela G.L. Carolina
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3. Conclusion