Danger – insurance ahead

Does deposit insurance really insure against trouble?


Even before 2008, banking crises were common around the globe. One study reports 160 calamities in more than 150 countries over two decades. The currency crash of 1997 cost Thailand and South Korea nearly a third of their GDP – and Indonesia, almost half -- thanks to tottering banks.

Small wonder, then, that depositors demand insurance. In 1974, only 12 countries offered deposit insurance; by 1999, 71 did, according to Asli Demirgüc-Kunt and Edward Kane. Kazakhstan has offered deposit insurance since 1999, through the Kazakhstan Deposit Insurance Fund. It’s owned by the National Bank of Kazakhstan, which initially kicked in a billion tenge for the till. The Fund said it had enough to pay for the failures of two mid-sized banks, or 7 billion tenge. That was before 2008-9, when two of the nation’s largest banks collapsed. A deposit had been insured for up to 400,000 tenge ($2,700 at today’s exchange rate). In 2008, the Fund increased coverage to 5 million tenge ($33,800).

Yet insurance may increase the chances of a bank collapse. After all, a fully-insured depositor no longer has reason to monitor the care that the bank takes in lending. The insurance may also make the banks careless about their loans, because they know that most of their depositors can get their money back, regardless of whether the borrower pays back. In the United States, most banks paid no premiums for their deposit insurance, even though the risk of failure was not zero, reported Fred Furlong and Simon Kwan in 2002.

By making the banks careless, the insurance creates a “moral hazard” – that is, a change in behavior, arising from a contract, that hurts one of the signers. For example, in the Eighties, savings and loan associations in the U.S. – which offered home mortgages -- often had little net worth, so they literally bet the bank on risky loans. They figured that if the loans paid off, then they would profit handsomely, because they could charge a high interest rate for risk. And if the loans went bad? No problem: The federal government would pay off the depositors, and the thrifts weren’t worth much, anyway. In 1989 alone, 327 thrifts failed, according to Antoine Martin. The banks were also more likely to take risks in the Eighties when their charter value fell. Less efficient banks took on more risk, more loans per dollar of assets, concluded Thomas Siems in 2002.

In this light, Kazakhstan’s exemption of bank executives and top shareholders from insurance in bank failures seemed to address a special moral hazard. (The Kazakhstan Deposit Insurance Fund didn’t insure deposits of top executives and of shareholders who owned more than 5 percent of the bank’s voting shares. Neither did it insure the so-called VIP deposits – time deposits that exceeded 7 million tenge.) If the bank executive didn’t even have his own money at stake, then why should he object to risky lending that may indirectly push up his salary?

Ironically, the U.S. government offered deposit insurance to try to save the banks, during the Great Depression of the 1930s. If depositors knew that the government would reimburse them, then they might not have reason to run on the bank, all of them demanding their money at once. During the Depression, deposit insurance seemed to work: The number of bank failures fell from 4,000 in 1933 to just over 50 banks a year from 1934 to 1941, wrote Martin.


Branching for safety


Today, as developing countries with undercapitalized banks adopt deposit insurance, the moral hazards are more evident. Statistical studies suggest that banking crises are more likely in countries with extensive deposit insurance, particularly if its institutions are weak – for example, if the government is prone to corruption. You would think that the government of a developing country could stave off a banking crisis by guaranteeing to repay the depositors. But if the government is poor, then its promise is not credible.

We need not insure deposits in order to protect them. The bank could instead diversify its risk by offering branches. For example, YourBank may have a branch in Almaty and another in Astana. When education turns down, due to a booming national economy that attracts potential students into jobs, then the Almaty branch may do relatively poorly; but the Astana branch will be swimming in cash, and this will protect depositors in Almaty. During the 1920s in the United States, banks with branches were less likely to fail than banks without branches, according to economic historians Jeremy Atack and Peter Passell. Even before 2008, the number of bank branches in Kazakhstan was declining, according to First Initiative.

If the depositors will monitor the bank, then it will lend with care. One way to ensure that the depositors keep an eye on their institution is to make them co-pay for deposit losses, suggested Demirgüç-Kunt and Kane.

Otherwise, the government could motivate the bank to exercise caution by charging rates for deposit insurance that rise with risk; that rise, in particular, with the percentage of loans that are bad, since it is hard for the regulator to know exactly which loans are risky. Maybe the bank will promise to extend only safe loans, in order to procure the low premiums, but then lend to risky enterprises, in order to earn high rates of return, suggested Edward Simpson Prescott.

The government can also make clear that the healthy banks must repay the deposits at failed banks. This will give the healthy banks an incentive to monitor its ailing brethren. Finally, the government can close weak banks before they go under. Under a 1991 law in the U.S., the feds could close any bank with a capital-to-asset ratio below 2 percent. That is, if the bank’s net worth is less than 2 percent of its assets, which are mainly loans, then the government can shut it down. This, at the least, avoids the expense of reimbursing the depositors in the event of a bank failure, noted Martin. Canada has a provision like this. As a consequence, when Canada introduced deposit insurance, the banks did not take many more risks. – Leon Taylor, tayloralmaty@gmail.com





Good reading


Charles Calomiris. Is deposit insurance necessary: A historical perspective. Journal of Economic History 50. Pp. 283-296. 1990.

Fred Furlong and Simon Kwan. Deposit insurance reform – when half a loaf is better. Federal Reserve Bank of San Francisco Economic Letter. May 10, 2002. Online.

Asli Demirgüc-Kunt and Edward J. Kane. Deposit insurance around the globe: Where does it work? Journal of Economic Perspectives 16:2, summer 2002, pp. 175-195. Online.

Antoine Martin. A guide to deposit insurance reform. Federal Reserve Bank of Kansas City Economic Review. First quarter 2003. Online.

Thomas F. Siems. Survival and the hump in the CAMELS. Federal Reserve Bank of Dallas Expand Your Insight. October 2, 2002. Online.

Edward Simpson Prescott. Can risk-based deposit insurance premiums control moral hazard? Federal Reserve Bank of Richmond Economic Quarterly. Pp. 87-100. Spring 2002. Online.

Jeremy Atack and Peter Passell. A new economic view of American history. New York: W.W. Norton. Second edition. 1994.

Eugene Nelson White. State-sponsored insurance of bank deposit in the United States, 1907-1929. Journal of Economic History 41. Pp. 537-58. 1987.



References


First Initiative. www.firstinitiative.org

International Association of Deposit Insurers. Member profile: Kazakhstan Deposit Insurance Fund. www.iadi.org

Kazakhstan Deposit Insurance Fund. Otveti na chasto zadavaemie voprosi (FAQ). The Fund does not offer a FAQ for depositors in English. www.kdif.kz