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v  This paper presents an overview of the characteristics and the effectiveness of deposit insurance arrangements in various countries as a platform for discussion of the possibility of applying a deposit insurance arrangement in Israel.
v  Many countries have established a deposit insurance arrangement in order to insure depositors’ money during a crisis and to prevent a “run on the banks”. The various countries differ in the type of insurance, the amount of coverage, and the institutional mechanism, among other things.
v  Deposit insurance has advantages, but also disadvantages. Moreover, during the crisis, deposit insurance programs were occasionally inadequate, and did not prevent the need for additional government support.
v  In Israel, there is no deposit insurance mechanism, but there is an implicit government guarantee.  In view of this, the Bank of Israel is examining the advantages and disadvantages inherent in such an arrangement, as well as the need and possibility of applying it in Israel.
 
A.    Background[1]
 
Instituting deposit insurance is intended to prevent a “run on the banks”—a situation in which depositors run to the bank during a crisis in order to withdraw their deposits, as a result of which a temporary liquidity shortage may lead to the insolvency of a bank or even to the expansion of the failure to the entire system.  The professional literature mentions a number of additional considerations in favor of deposit insurance:
v  It increases competition and reduces concentration provided the insurance relates separately to deposits in various banks, and not to the total deposits made in the banking system. This is because it encourages the depositors to distribute their deposits among various banks in order to ensure a larger amount.[2]
v  It reduces the burden on public expenditure in times of crisis.
v  It provides depositors with a fair amount of certainty with respect to their ability to quickly withdraw the deposit.
v  It constitutes part of the international standards, including standards set by the OECD and the Financial Stability Board (FSB).
 
However, there are also disadvantages to deposit insurance:
v  It increases the moral hazard since it encourages the management and shareholders of the bank to take larger risks in order to increase profits.
v  It reduces market discipline because it undermines the motivation of depositors to monitor the risk inherent in management’s behavior and the depositors’ motivation to take sanctions— by withdrawing deposits—when the risk increases.
v  It could increase the prices of banking services if the banks impose the financing costs of the insurance mechanism—even partially—on depositors.
 
As we will see below, safety nets such as deposit insurance have, during crises, contributed to financial stability in the countries that have instituted them. However, in order for the advantages of deposit insurance in times of a crisis to outweigh its disadvantages during routine times, it must be implemented with proper supervision.  Moreover, the experience gained in the recent crisis strengthened the position that in order to prevent the failure of a large bank from adversely affecting the entire financial system, deposit insurance is not sufficient, and an implicit government guarantee is required.[3]
 
B.     The qualities of deposit insurance
 
Distribution: Deposit insurance is the most common method used by countries to insure depositors’ money during a crisis, and the number of countries that have such insurance increased significantly in recent years—from 84 out of 189 countries in the sample in 2003 to 112 out of 189 at the end of 2013. In Europe, 96 percent of countries have deposit insurance. 
Amount of coverage: The amount of insurance coverage varies significantly from country to country, both in absolute terms and relative to per capita income, and ranges from coverage of small amounts—€50,000 and even less—to full coverage.  Countries in the Eurozone determined that the insured deposit amount would be €100,000; the UK set the amount at £85,000, the US at US$250,000, and Australia at AUD 250,000.
 
Coverage:  Some insurance mechanisms (about 43 percent) ensure the repayment of insured deposits only when the bank becomes insolvent, while the rest include additional areas of responsibility, such as responsibility for minimizing loss and risks to capital, by exercising monitoring and control authority over insured entities.  These other areas vary according to the banks’ license, the supervisory authority, and the ability to gather information from banks.
 
The mechanism: Deposit insurance mechanisms have diverse mechanisms.  Some of them receive “ex-ante financing”, via a fund accrued from the insured banks’ premiums, and some receive “ex-post financing”, by reimbursing the depositors of a bank that has become insolvent and then collecting premiums from the banks.
 
Managerial entities: In 66 percent of the countries, the government manages the insurance mechanisms, albeit with great variance between countries.  In developing countries, the governments manage 82 percent of all insurance programs, whereas in advanced countries, they manage 44 percent.  In these countries, the banks manage 21 percent of the insurance mechanisms, with the remaining 35 percent managed jointly by the government and private entities.
 
Financing: Financing deposit insurance comes first and foremost from the premiums paid by the insured banks, although some of the insurance mechanisms receive partial or complete government funding.  When the funding is joint, the initial portion comes from the government, and the remainder from the banks’ ongoing payments.  77 percent of all insurance are privately funded, 2 percent by the government, and the remaining 21 percent are jointly funded.  In this respect, there is considerable variation between countries. In countries where per capita income is high, the private sector finances 91 percent of the insurance mechanisms.
 
Government guarantee: About 38 percent of insurance mechanisms enjoy government support in the event that capital is insufficient, and for the most part, the Ministry of Finance provides lines of credit or guarantees for the issued debt. The extent of the guarantee is greater in countries with high per capita income, because their financial status warrants it.
 
Legal status:  Deposit insurance usually (in 86 percent of the cases) constitutes an independent legal entity, separate from the central bank, banking supervision, or the Ministry of Finance.
 
C.    The question of the effectiveness/efficacy of deposit insurance during a crisis
 
A study published last year examined the connections between bank risk and deposit insurance, and the fragility of the financial system in the years preceding the 2008 crisis and during it.[4]  The study found that in countries that have deposit insurance, the negative effect of moral hazard—i.e., taking greater risks—increases during routine times, whereas the positive effect on stability increases during crises.  It was also found that efficient and strong supervision and regulation increase the positive effect of deposit insurance during crises and reduce the negative effects of moral hazard during routine times.
Deposit insurance, together with the central banks’ actions to increase liquidity and facilitate monetary easing, helped in preventing a "run on the bank".  By way of illustration, the broad liquidity support provided by the Federal Reserve to the banks, together with the understanding that the Treasury would provide fair support to the Federal Deposit Insurance Commission (FDIC), prevented a run on deposits of the banks insured by the FDIC.  In addition, brokers’ money market funds[5], with no insurance, received temporary federal insurance when the crisis strengthened in September 2008, and recorded massive amounts of redemptions.
Deposit insurance may therefore moderate a "run on the bank" during a crisis, but it seems that it cannot adequately prevent it.  In Europe, there is deposit insurance, but it did not prevent a "run on the bank" in the Northern Rock case in England[6] or in the DSB case in the Netherlands.  In Greece too, there was a marked withdrawal of deposits due to the concern that it might pull out of the eurozone and abandon the euro, but the withdrawal was conducted relatively slowly (deposits declined by 20 percent between 2010 and 2012.)
A review of the measures taken by countries to stabilize the financial system during the last crisis shows that deposit insurance did not obviate the need for an implicit government guarantee. Many countries provided guarantees that covered deposits in excess of the insurance coverage stipulated by law, and even added a government guarantee for other assets and liabilities of the banks with the aim of maintaining public confidence in the banking system. Government intervention during the crisis was not limited to balance sheet liabilities, and in 2008, 17 countries nationalized a significant part of the financial system (64 percent of countries that experienced a banking crisis and have deposit insurance).
 
D.    Summary
 
The recent financial crisis emphasized four facts or developments. First, deposit insurance does not obviate the need for an overall safety net, particularly regarding banks with systemic importance. The interconnectedness between the banking system and the markets indicates that funding crises in the capital markets can easily spill over to the banks, and funding crises in the banks can rapidly spill over into the capital markets and even into the real economy.  History shows that when a real crisis is the result of a financial crisis, it is deeper and longer. The systemic risk from such a spillover emphasizes how important it is to expand the safety net to nonbank entities as well.
Second, one of the most significant tools available for resolution of a failing bank—particularly in the case of medium and large banks—is a designated fund. Most European countries did not have such a designated fund in 2008, and if there were funds, they had accumulated only small amounts. Therefore, the Eurozone recently formulated new legislation transitioning to an overall European fund for financing in future financial crises.  This fund is to replace the single mechanism for resolution.
Third, there is a recent tendency in the world to reduce the exposure of public funds to the risk derived from the need to extricate failing banks, particularly large and medium banks. Policy papers from regulators abroad contain wide-ranging discussions of the appropriateness of shareholders and non-secured bond holders bearing the costs inherent in the failure of the firm[7] before government assistance is provided.
Finally, before the crisis, many countries attempted to reduce the negative effect of deposit insurance on market discipline and on moral hazard through a low level of insurance coverage and/or joint insurance, with the intention of providing incentives for insured retail depositors—as well as other parties—to monitor the financial institutions.  The results of the crisis show that this attempt failed, and as of 2013 only 3 countries left such insurance mechanisms in place.
The lessons learned from the financial crisis led the International Association of Deposit Insurers (IADI) in November 2014 to publish an update to the core principles of an efficient deposit insurance system.  The publication contains 16 principles which pertain, among other things, to the clarity of the objectives of the deposit insurance mechanism, the powers of the insurer, the insurer’s independence, the insurer’s connections to the other parties participating in the financial safety net, the level of insurance coverage, supervision and monitoring, the program’s participants (the requirement that all the banks participate in it), the sources and uses of financing, and more.
In Israel, there is an implicit government guarantee, but there is no deposit insurance agency. In light of this, the Bank of Israel is examining the advantages and disadvantages inherent in such an arrangement and the need and possibility of applying it in Israel.
 
                                                                                                          
Structure of the deposit insurance mechanism: comparison of selected countries according to December 2013 data[8]
 
Australia
Chile
UK
US
Switzerland
Sweden
Singapore
Japan
Canada
Germany
France
Type of deposit insurance  program
Explicit
X
X
X
X
X
X
X
X
X
X
X
Legally separate
 
 
X
X
X
 
X
X
X
X
X
Central bank, supervisor or ministry
X
X
 
 
 
X
 
 
 
 
 
Publicly administered
X
X
X
X
 
X
X
 
X
 
 
Privately administered
 
 
 
 
X
 
 
 
 
 
 
Jointly administered
 
 
 
 
 
 
 
X
 
X
X
For deposits only (pay-box only)
X
X
 
 
X
X
X
 
 
 
 
Pay–box plus  loss or risk minimization
 
 
X
X
 
 
 
X
X
X
X
Multiple programs
 
 
 
X
 
 
 
X
X
X
 
Participation and Coverage
Compulsory for domestic banks
X
X
X
X
X
X
X
X
X
X
X
Local subsidiaries of foreign banks
X
X
X
X
X
X
X
X
X
X
X
Local branches of foreign banks
 
X
X
 
X
 
X
 
 
X
X
Foreign currency deposits
 
X
X
X
X
X
 
 
 
X
X
Interbank deposits
X
 
 
X
 
 
 
 
X
 
 
Funding
Ex-ante funding
 
 
 
X
 
X
X
X
X
X
X
Ex-post funding
X
X
X
 
X
 
 
 
 
 
 
Funded by government
X
X
 
 
 
 
 
 
 
 
 
Funded privately
 
 
X
X
X
X
X
X
X
X
X
Funded jointly
 
 
 
 
 
 
 
 
 
 
 
Contributions and Assessment Base
Risk-adjusted premium
 
 
 
X
 
X
X
 
X
 
X
Covered deposit
 
 
 
 
 
X
X
X
X
 
 
Eligible deposit
 
 
X
 
 
 
 
 
 
X
X
Total deposits
 
 
 
 
 
 
 
 
 
 
 
Total liabilities
X
X
 
X
X
 
 
 
 
 
 
Payouts to depositors
Per deposit account
 
X
 
 
 
 
 
 
 
 
 
Per depositor and per institution
X
 
X
X
X
X
X
X
X
X
X
Per depositor
 
 
 
 
 
 
 
 
 
 
 
 

[1] The data in this survey are from Demirguc-Kunt A., E. Kane and L. Laeven (2014), "Deposit Insurance Database", Policy Research Working Paper 6934, The World Bank – Development Research Group.  This paper includes a comparison of deposit insurance data from 188 members of the International Monetary Fund, including Liechtenstein.
[2] By way of illustration, if the insurance amount is NIS 100, and the depositor deposits NIS 1000 in one bank, he will receive NIS 100 from the insurance.  But if he divides his deposit among two banks, he will receive NIS 200.
[3] In professional jargon, an implicit guarantee is also called “cover”, and relates to a guarantee that a government may grant in order to protect financial stability even if such a possibility is not explicitly set out in legislation.
[4] Anginer D., A. Demirguc-Kunt and M. Zhu (2014), "How does deposit insurance affect bank risk? Evidence from the recent crisis", The Journal of Banking and Financing No. 48.  The sample included 4109 banks in 96 countries.  The measurement was conducted on data from 2004 to 2009.  Data from 2004–2006 present the period preceding the crisis, and the data from 2007–2009 present the crisis period.  In order to find the effect of deposit insurance, the researchers compared the risk indices in countries with deposit insurance to the indices in countries without deposit insurance.  The bank risk was calculated according to the Z value, which assessed the volatility of asset yields, while the fragility of the system was calculated according to an index of expected losses of a company as a result of price declines in the markets.
[5] These are funds that invest in short-term quality assets (bank deposits, government securities and tradable securities) and that have a stable net asset value of $1.  (The net asset value equals the value of the fund’s assets minus its liabilities.  A decline below $1 means that the fund is expected to generate losses for its investors.)
[6] The UK established special deposit insurance.  The initial part of the deposit amount was not insured—only the amount that exceeded that was.  However, this did not prevent the collapse of Northern Rock, since no depositor was prepared to lose the first few thousand pounds.  The literature written before the crisis praised the British arrangement because it expanded personal liability, but it turned out that the market discipline that appeared correct theoretically did not meet the test of reality.
[7] Bail-in.
[8] Source: Demirguc-Kunt A., E. Kane and L. Laeven (2014), "Deposit Insurance Database", Policy Research Working Paper 6934, The World Bank – Development Research Group.