Pricing of Deposit Insurance

1. Pricing of Deposit Insurance Luc Laeven Finance Forum 2002

2. Pricing of Deposit Insurance • Explicit deposit insurance should not be adopted in countries with a weak institutional environment (Demirgüç-Kunt and Kane 2002) • But: for countries that decide to adopt deposit insurance, pricing it as fairly and accurately as possible is important • Example: Russia

3. Outline • Deposit insurance pricing methods • How do specific deposit insurance design features affect the price of deposit insurance? • Is deposit insurance underpriced around the world?

4. Method I: Equity Price Experience • Deposit insurance can be modeled as a put option on the bank’s assets (Merton, 1977) • Input parameters: • Volatility of equity returns • Bank leverage (market value of equity over debt) • Degree of regulatory capital forbearance • Limited application: • Need market valuation of the bank’s net worth (listed banks in market-oriented countries)

5. Method II: Default Experience • Expected loss pricing Expected loss=Expected default probability*Exposure*Loss given default • Expected loss = Size of the loss to the deposit insurer as percentage of insured deposits • Expected default probability = The bank’s estimated probability of default • Exposure = Amount of insured deposits • Loss given default (LGD) = Loss to deposit insurer as a percentage of the total defaulted exposure

6. Estimating LGD • Historical experience of deposit insurer • US FDIC’s historical loss rate equals 8% of bank assets • In developing countries, loss rates of 50 % and up are typical • Good indicators: loan concentration, business mix, structure of bank liabilities

7. Estimating Default Probability • Historical default probabilities • Implied by historical losses of the deposit insurer • Implied by a bank’s credit ratings on deposits • Implied by a bank’s interest rates on uninsured debt (e.g. interbank deposits, subordinated debt) • p=(y - rf )/(1+y), where p is probability of default on default risky debt, y is the yield on a zero-coupon default risk debt, and rf is the yield on a zero-coupon default risk-free debt (all with the same maturity)

8. Application: Equity prices

9. Application: Credit Ratings

10. Pricing Design Features • Ex-ante funding vs. ex-post funding • Flat-rate premium vs. risk-based premium • Levy on total deposits vs. levy on insured deposits • Broad coverage vs. narrow coverage • Coverage limit • Co-insurance • Include or exclude foreign-currency deposits

11. Design feature Coverage limit Co-insurance FX deposits Interbank deposits Funded Management Compulsory membership Risk-based premium 3.2 times per capita GDP 28% of countries 68% of countries 26% of countries 87% of countries 51% of countries public 87% of countries 41% of countries Comparing Design Features

12. Insurability • Insurability of a risk is greater if: • Losses occur with a high degree of randomness • Maximum possible loss is very limited • Average loss amount upon occurrence is small • Losses occur frequently • Insurance premium is high • Possibility of moral hazard is low • Coverage of the risk is consistent with public policy • The law permits the cover

13. Insurance Coverage and Premia • Cost of deposit insurance can be dramatically reduced by reducing the coverage of insurance • Reducing the coverage reduces (at least) proportionally the deposit insurance cost • Reduction in actuarially fair premium could be larger if the reduction in the coverage reduces the asset risk of the bank • Since the per dollar premium is higher with higher asset risk, limiting the coverage has a larger impact on reducing the cost of deposit insurance in developing countries

14. Risk Diversification and Premia • Non-systemic risk can be diversified away by pooling assets of banks • Potential for risk diversification is larger in: • larger countries; countries with many banks; countries with different types of banks (ceteris paribus) • Price of deposit insurance of a group of banks is lower than the weighted average of the price of deposit insurance for each individual bank • Case-study: Korea. Fair premium (% of deposits): • 2.81%, if measured as weighted average of individual premia • 1.44%, if measured as a pool of assets

15. Risk Differentiation and Premia • Exclusion of risky banks can significantly reduce the cost of deposit insurance • Unless some of these banks have great diversification potential • Case-study: Korea. Fair premium (% of deposits): • 1.44% (if measured as a pool of assets) – all banks • 1.28% (if measured as a pool of assets) – excluding the three riskiest banks (in terms of equity volatility)

16. Is Deposit Insurance Underpriced? • For comparison purposes, estimated fair premiums should be expressed as a percentage of insured deposits • Estimated fair premiums are higher than actual premiums in many countries – even if estimated on the basis of conservative estimates • On the basis of equity prices: • No capital forbearance: 5 out of 21 countries (24%) underpriced • With 3% capital forbearance: 9 out of 21 countries (43%) underpriced • On the basis of bank credit ratings: • 8% loss rate: 5 out of 32 countries (16%) underpriced • 50% loss rate: 22 out of 32 countries (69%) underpriced

17. Pricing the Adoption of Deposit Insurance: The Case of Russia • Alternative methods: • Compare with actual premiums and historical losses in other (comparable) countries • Estimate actuarially fair premium on the basis of the discussed methods • Take design features into account • Estimates of fair premium for Russia are higher than the proposed premium of 0.6% of deposits • Default experience suggests a premium of about 4% • Equity price experience suggests a premium between about 2% and 4% (or even higher depending on the enforcement of capital rules)

18. Conclusions • Explicit deposit insurance should not be adopted in countries with weak institutional environment • Pricing deposit insurance as accurately as possible is important, but not easy • However, there are several methods that can help in estimating actuarially fair premiums • There exist several design features that can limit the cost of deposit insurance