Can deposit insurance prevent a new banking crisis?

As governments struggle to construct a truly global financial safety net, they must identify the lessons of the last crisis. A particular concern is the extent to which government propensities to rescue financial institution creditors undermine market discipline (see e.g. Acharya et al. 2010) and redistribute world income in anti-egalitarian ways (Kane 2014).

To help in this task, we have updated our database on the character of deposit insurance arrangements around the world through 2013. Our data show how different countries handled crisis pressures.

Our starting point was the survey on regulation and supervision the World Bank conducted in 2010. Besides collecting data on the specifics of a country’s deposit insurance arrangements, this survey asked national officials for information on capital requirements, ownership and governance, activity restrictions and bank supervision.

We combined these data with deposit insurance surveys conducted by the International Association of Deposit Insurers in 2008, 2010 and 2011. For European countries, we were able to obtain detailed information on deposit insurance arrangements from the European Commission (2011). Finally, we checked discrepancies and data gaps against other sources, including national deposit insurance laws and regulations, and IMF staff reports. Following Demirgüç-Kunt et al. (2008), we assume any country that lacks an explicit deposit insurance scheme will show a commitment to provide implicit deposit insurance in the event of widespread banking insolvency.

The number of countries with explicit deposit insurance schemes has continued to increase. From the 189 countries we studied, 112 (59%) had explicit deposit insurance by year-end 2013 – a sharp increase from 84 countries (44%) in 2003. The great financial crisis of 2008 influenced this trend, with five countries adopting deposit insurance in that year alone. Australia, long an advocate of implicit deposit insurance, stands out as a notable example of countries that switched to explicit deposit insurance in 2008.

In Europe, the crisis-driven expansion of deposit-insurance systems was intensified by the EU’s efforts to harmonise deposit insurance. Harmonisation spurred the adoption of explicit schemes across central and eastern Europe. Today, almost all European countries (96%) have explicit deposit insurance. Formal deposit insurance remains less widespread in other parts of the world. For example, only 24% of African countries offer explicit deposit insurance.

Figure 1. Explicit deposit insurance by income group, 2013

Coverage limits still vary markedly across countries, whether measured in dollars or relative to per capita income (see Figure 2). Coverage surged during the recent financial crisis as government guarantees of deposits were announced. Though some guarantees were subsequently reduced, average coverage levels remain above pre-crisis levels. By the end of 2013, coverage limits averaged 5.3 times per capita income in high-income countries; 6.3 times per capita income in upper-middle-income countries; 11.3 times per capita income in lower-middle-income countries; and 5.0 times per capita income in low-income countries.

Figure 2. Coverage increased during the crisis and remains above pre-crisis levels

The expansion of the safety net was substantial, especially in crisis countries. Fourteen countries introduced explicit deposit insurance since 2008, and almost all crisis countries that already had explicit deposit insurance increased the statutory coverage limit in their scheme (96% of these countries, to be precise). Additional government guarantees of deposits were introduced in 32% of these crisis countries; 38% of government guarantees were blanket guarantees, backing deposits in full. Government guarantees on bank liabilities were particularly widespread, especially among crisis countries (72% of these countries extended guarantees on bank liabilities). Guarantee programmes varied from extending guarantees on new debt issuances to blanket guarantees on all bank debt. Government guarantees on bank assets were used in 36% of the crisis countries that had explicit deposit insurance. Bank nationalisations occurred in 64% of these countries.

To measure the generosity of a nation’s deposit insurance scheme and additional government guarantees on bank assets and liabilities, we developed a safety net index. Our index generalises the moral hazard index introduced in Demirgüç-Kunt and Detragiache (2002). The safety net index is computed using principal component analysis of indicators for design features. Each feature is defined so that it is increasing in moral hazard. The index itself is the sum of the first six principal components for which the eigenvalues exceed unity.

Our final graph (Figure 3) shows the values of our safety net index for selected countries. The variation in the index is remarkable. It ranges from lows of -11.9 in Argentina and -10.5 in Iceland (both of which imposed losses on insured depositors) to highs of 4.6 in Ireland and the US (both of which issued temporary guarantees on deposits and non-deposit liabilities during the crisis), 4.5 in Turkmenistan, and 7.8 in Uzbekistan (both of which adopted blanket guarantees).

Figure 3. Safety net index, 2013

Whether or not all of these countries can fund their generous safety-net promises, the fairness and efficiency of imposing such a burden on a country’s households and non-financial firms deserve study. Moreover, the moral hazard that generous promises engender intensify “too big to fail” and “too many to fail” problems.

It is too early to draw definitive conclusions about the reliability of further deposit insurance expansion as a tool for managing the next global financial crisis. Our preliminary assessment is that, by and large, deposit insurance fulfilled its primary purpose of preventing open runs on bank deposits. There were a few notable runs (such as at Northern Rock in the UK) and some protracted withdrawals by uninsured depositors. But deposit insurance delivered on its foremost objective – the world avoided an open global run on its banks.

As we look ahead to what, we hope, are many post-crisis years, the tendency to expand financial safety nets (through extended coverage, increased reliance on government guarantees, and government rescue propensities) is something to worry about. The expansion of national safety nets raises questions about:

• Whether in some countries government finances are adequate to support the promises of existing deposit insurance coverages in future periods of stress; and
• How to temper the concern for eliminating bank runs to control the distorting effects that deposit insurance has on the character of risk-taking at protected firms.

A more comprehensive analysis of these issues is needed. We hope that publishing this database will facilitate this research.

Published in collaboration with Vox

Authors: Asli Demirgüç-Kunt, director of research at the World Bank, Edward J Kane, professor of finance, Boston College and Luc Laeven, deputy division chief in the Research Department of the International Monetary Fund and CEPR Research Fellow.

Image: Signs explaining Federal Deposit Insurance Corporation (FDIC) and other banking policies are shown on the counter of a bank in Westminster, Colorado. REUTERS/Rick Wilking