Deposit insurance systems (DIS) play a key role in building confidence among depositors and helping keep their money safe. However, deposit insurance should never be considered a "magic bullet," a "quick fix" or a stand-alone solution to maintain financial stability.
The 2008 global financial crisis created a crisis of confidence in banking systems around the world. As a response, the number of countries with deposit insurance systems quickly shot up from 84 (in 2003) to 125 (in 2016). For the existing DIS, this period tested their design and effectiveness.
Over the past decade, the FIRST Initiative has funded 16 projects across the globe to assist in strengthening existing deposit insurance systems or establishing new ones. Drawing from these experiences, we recently published a Lessons Learned Note on the Challenges in Building Effective Deposit Insurance Systems in Developing Countries. The note provides seven lessons learned from our work across the six World Bank regions and provides a number of specific country examples.
The note provides insights to better understand: (1) the role of a DIS, (2) how to design an appropriate framework and (3) keys to effective implementation and operations.
Can a DIS cure a weak banking system?
Deposit insurance is only one aspect of a much broader financial sector safety net, and it only works when certain preconditions have been met and when the other elements of the safety net are also working. Therefore, a deposit insurance system is not a "cure" for weak banking systems and it cannot, by itself, be expected to manage a systemic failure.
In order for a DIS to be effective, there are certain conditions that must be in place. These include macroeconomic stability; a healthy banking system; strong prudential regulation and supervision; an effective bank resolution framework; a developed legal framework with efficient courts and procedures; and a strong accounting and disclosure regime.
The effectiveness of a DIS depends largely on the broader safety net in which it operates. For example, a strong and effective supervisory system can help prevent bank failure through early detection and intervention in problem banks followed by recovery measures or the use of enforcement tools. However, when failures do occur, the safety net should also have a strong and cost-effective bank resolution framework.
What does the ideal DIS look like?
In our experience, we have found that there is no one-size-fits-all approach to DIS. Instead, such systems are likely to be more effective if they are appropriately tailored to the level of development of the financial system and the country context. Therefore, in designing a DIS, policymakers are required to make critical policy choices about the policy objective, the mandate, the institutional setup, and the membership, funding and coverage levels. These design features must be considered in line with the globally accepted good practices for deposit insurance.
As the context in which the DIS was initially built changes over time, so too should the DIS. This could mean that a DIS that started as a pay box system could later assume more resolution or supervision powers. Similarly, an operationally independent DIS established within another institution like a central bank, could overtime transition towards a separate institution.
What comes next?
Once a deposit insurance program has been appropriately designed, there are several important financial, operational and strategic decisions to consider. Authorities must establish a target reserve fund size that is based on clear and consistent criteria. This is critical to appropriately pricing bank premiums, and to ensuring that the program is prepared to reimburse depositors when needed. The payout process is the most fundamental task of the DIS but, surprisingly, one that most DIS, even experienced ones, are challenged to achieve. Quick and efficient payouts are essential to limiting disruption, maintaining stability and restoring public confidence. However, reimbursements are often delayed due to poor recordkeeping, inadequate IT systems and lack of resources. Thus it’s important to regularly perform crisis simulations and to test the system’s capabilities.
Once the DIS becomes operational, it is equally important that authorities test and re-evaluate on a continuing basis the effectiveness of the DIS framework. Policymakers should build in capacity to adapt dynamically to the financial changes, and they should schedule periodic assessments to review coverage levels and other factors — especially after financial crises or other systemic market events.
Each of these lessons provide insights into the ideal design and function of an effective deposit insurance system. Although a DIS is not a magic bullet, deposit insurance can play an important role in times of financial crises. Without it, depositors are much more likely to stage a run on the banks, withdraw their savings and accelerate market failures.
Unfortunately, there are still several countries that have yet to set-up a DIS: For example, only 24 percent of countries in Sub-Saharan Africa currently have a DIS. Hopefully, these lessons will prove useful to authorities in establishing new DIS, or strengthening existing ones.
To read the full Lessons Learned Note, please click here.
Photo Credit: Hendri Lombard / The World Bank