Deposit protection for banks has been around for a long while. Czechoslovakia was the first country to establish a national level deposit insurer, in 1924, followed by the United States ten years later. Today, 146 countries have implemented deposit insurance mechanisms for their banking systems, according to the International Association of Deposit Insurers. For credit unions or financial cooperatives, however, the picture could not be more different. A recent survey by the International Credit Union Regulators’ Network (ICURN) showed that only 21 percent of the surveyed non-G20 countries had deposit insurance for credit unions.
The need to extend deposit insurance to financial cooperatives is showcased by recent events in Nepal. Financial cooperatives have become a popular means of pooling investment funds in the country, especially among the lower-income Nepalese. But poor investments, lack of government regulation and supervision, and fraudulent acts by managers have undermined cooperatives, causing hundreds of them to close down in the past few years. Without deposit insurance to guarantee at least part of their savings, thousands of depositors have lost substantial amounts of money, which led to cases of mental breakdowns, heart attacks, and suicides.
Credibility and awareness
Once depositors suspect that a market player is failing, they will be tempted to withdraw their money, accelerating the demise of the institution and frequently the demise of other institutions in the same segment. A trustworthy deposit insurance scheme can rein in these fears, mitigating the spread of a crisis.
From the depositors’ point of view, a deposit insurance guarantees that their savings are protected, and that they will be able to continue to access their funds even if the institution fails. Micro and small enterprises will have continuous access to their working capital, families will be able to continue to spend their earnings, and the overall impact of the failure will be minimized.
A deposit insurer needs to have sufficient reserves and backstop funding lines to ensure that it will be able to compensate depositors. It also needs adequate systems and information to be able to pay out quickly. The International Association of Deposit Insurers (IADI) standards suggest that payouts should be available within seven days of the failure.
But another aspect—as important as credibility—is awareness: Depositors must know that their money is protected and that they do not need to withdraw their deposits upon hearing the slightest rumor that a bank may fail. To achieve this, deposit insurers must invest in public awareness, and require financial institutions to inform their clients.
To avoid confusion, all institutions taking deposits must be members of the deposit insurer. The ICURN survey shows that among countries that have deposit insurance for credit unions, a significant portion have voluntary systems. By leaving some cooperatives out, these countries undermine the effectiveness of their deposit insurance schemes and increase the risk of a run on deposits at all financial cooperatives, as the general public may not easily distinguish covered institutions from those that are not.
Addressing challenges before implementation
Depending on the country where they are located, financial cooperative sectors present different challenges that impact the implementation of deposit insurance. In some cases, financial cooperatives are supervised with less rigor or not supervised at all. In many countries, they report to an authority that oversees all different types of cooperatives or to a ministry, rather than to the specialized financial sector supervisor. Often, they do not have minimum capital, liquidity requirements, or exposure limits, which makes their business riskier than that of a bank.
In many instances, financial cooperatives—especially the smaller ones—do not have systems in place to gather, process, and store data. It is not uncommon to see financial cooperatives that do all their record-keeping on paper or on simple spreadsheets. This creates significant operational difficulties for the deposit insurer, which will struggle to gather depositor information and prepare for a payout.
The transition from a system with no deposit insurer to a system where deposits are insured is a risky one for the deposit insurer. Many financial cooperatives may be in a fragile situation and may fail soon after the fund is created—before it has had the time to accumulate sufficient reserves.
These issues need to be addressed before a deposit insurance is implemented.
The World Bank has assisted numerous countries in dealing with this transition, through the assessment of the cooperative sector and the development of solutions to allow weaker players to either consolidate or merge into bigger institutions or to exit the market. In Albania, members of financial cooperatives are now fully insured by the deposit insurance agency, and there are ongoing initiatives in Moldova, Guinea, and in some Caribbean jurisdictions, to name a few examples.
Many development institutions and authorities worldwide have invested heavily in financial inclusion to ensure that individuals have access to useful and affordable financial products and services that meet their needs. In addition, they have supported or taken measures aimed at consumer protection: Mechanisms to ensure that contracts are fair, that consumers are provided with the necessary information, and that fees are under control. But all these measures apply on a “going concern” basis, while the provider is operating and can honor its financial obligations. Once a credit union fails, and the money is no longer accessible, consumer protection measures cannot do much, and that is when deposit insurance can make a substantial difference.