Funding of Deposit Insurance Systems

1. Presented by: Mr. Dong Il Kim, Executive Director Korea Deposit Insurance Corporation IADI Fifth Annual Conference Rio de Janeiro, Brazil November 15-17, 2006 Funding of Deposit Insurance Systems

2. Organization of Presentation • Introduction and Purpose • Rationale for Deposit Insurance Funding • Deposit Insurance Funding Methods • Sources of Funds for the Deposit Insurance System • Deposit Insurance Assessments • Determining the Optimal Size of a Deposit Insurance Reserve • Management of Deposit Insurance Funds • Transparency and Disclosure applied to Funding • Other Types of Funding Arrangements available to Deposit Insurers • Conclusions

3. I. Introduction and Purpose • Purpose • Provide practical advice on the design of funding arrangements for deposit insurance systems • Focus • Relative merits of various funding approaches • Options for funding sources • Calculation of reserve targets • Fund management • Assessment base • Calculation of premiums

4. Suggested Guidance #1 A deposit insurance system (DIS) must have ready access to adequate funds to ensure the prompt reimbursement of depositors’ claims. Rationale Mandates of a DIS are to contribute to financial stability by protecting the financial system. In order to fulfil its mandates, DIS should have adequate financial resources. II. Rationale for Deposit Insurance Funding

5. III. Deposit Insurance Funding Methods (1) • Three types of funding methods • Ex ante funding system involves the advance accumulation and maintenance of a fund to cover deposit insurance claims. The fund is primarily premiums collected from the members of the deposit insurance system. • Ex post system means that funds to cover claims are only collected from members when a member institution fails and there is a need to cover deposit insurance claims. • A hybrid system combines elements of ex ante and ex post funding.

6. III. Deposit Insurance Funding Methods (2) • Suggested Guidance #2 • Policymakers can choose among ex-ante, ex-post and combined (i.e. hybrid) approaches; however, an ex ante approach is preferable in most circumstances particularly for newly established systems. A disadvantage of systems that mainly rely on ex post funding is that they exacerbate financial cycles. Member institutions may be called on to make substantial payments into the system when they are least able to do so.

7. III. Deposit Insurance Funding Methods (3)

8. Sources of funds The sources of funds for a deposit insurance system can come from the private sector, the public sector or both. Most countries operate a system that relies on private funding to a large extent. Private sources Member institutions pay mandatory premiums as one of the conditions of membership. Public sources Most DIS have access to public sector fund in the form of initial contributions, loans from government or central bank and grants to cover losses. IV. Sources of Funds for the Deposit Insurance System (1)

9. Suggested Guidance #3 & #5 The cost of a DIS should be borne by its member banks, since they and their clients are the direct beneficiaries of a DIS. However, the impact of premium levels on the financial health of the banking industry should be taken into account. It is important for policy makers to take into account the impact of the establishment and operation of a deposit insurance fund on the capital base and lending capacity of member banks. Rationale Member institutions and their clients receive benefits from DIS so most countries operate a system that relies on private funding to a large extent. Excess premium may weaken capital base of member institutions and lead to the instability of financial system. IV. Sources of Funds for the Deposit Insurance System (2)

10. V. Deposit Insurance Assessments (1) • Definitions • Assessment base is the base of deposits on which premiums are assessed. It may include only insured deposits, but can include all types of deposits that are potentially insurable or all deposits • Premium is the amount a member institution pays for deposit insurance for a given period of time such as a year. • Defining an assessment base • The most common assessment bases are insured and total deposits. • Insurable deposits are defined as all deposits in all categories that are insured, including amounts in excess of the limit on insurance claims. • Insured deposits are the amount of deposits that are protected within the limit of insurance claims.

11. V. Deposit Insurance Assessments (2) • Premium systems: flat rate and risk-adjusted • Flat-rate premium system means all member institutions are assessed at the same rate given the assessment base • Risk-adjusted (differentiated) premium system means the risk posed by a member institution to the deposit insurer is incorporated into the premium structure. • Flat-rate premium system • Advantage: Relatively straight forward to implement • Disadvantage: Inequitable since low risk institutions subsidize high risk institutions • Risk-adjusted premium system • Advantage: More equitable since cross-subsidization among institutions is reduced • Disadvantage: more complex and expensive to administer

12. Suggested Guidance #6 A deposit insurance reserve fund can be built-up and maintained in at least two ways. One approach is to employ a steady premium rate over a lengthy period. Alternatively the premium system can be designed to maintain a target reserve ratio or range; the target reserve ratio must be sufficient to cover the potential losses of the insurer under normal circumstances. Rationale There are two basic approaches to create a insurance fund or reserve. A steady premium can be assessed over an extended period; alternatively, a premium system can be designed to achieve and maintain a target reserve level or range. The target level should be at least adequate to cover the potential losses of the insurer under normal circumstances as deposit insurers and member institutions can be exposed to a wide range of risks. VI. Determining the Optimal Size of a Deposit Insurance Reserve (1)

13. Suggested Guidance #7 A wide range of factors need to be taken into account for the target reserve ratio approach. These include: characteristics of the banking sector such as the number and size of banks, the liabilities of member banks and the risk exposure of the insurer to them, the likelihood of failures and the characteristics of losses typically experienced by the insurer. Deposit insurers can find themselves exposed to unexpected developments that can have a bearing on funding adequacy. Rationale A large number of factors need to be taken into account including: the composition of member banks (number, size, lines of business), the liabilities of members and the exposure of the insurer to them, the probability of failures and the characteristics of losses that the insurer can expect. VI. Determining the Optimal Size of a Deposit Insurance Reserve (2)

14. Suggested Guidance #8 It is possible for the target reserve approach to eventually generate more funds than the DIS requires. In those cases it is advisable to have a mechanism in place to handle such a situation. A disbursement mechanism for surplus funds should take into account factors such as the assessment base of each bank, past contributions to the fund and the risk profiles of member institutions. Rationale When targeted reserve is reached, deposit insurer may link rebates to past contributions and the current risk profile of the bank in question. This approach can also be applied to deposit insurance systems which use differential or “risk-adjusted” premiums. Just as premium rates applied to banks can be differentiated or risk-adjusted so too can rebates. VI. Determining the Optimal Size of a Deposit Insurance Reserve (3)

15. Suggested Guidance #9 Should there be more than one type of financial institution that accepts deposits, it is possible have one overall fund for all institutions or a separate fund for each category of institution. In the latter case it is necessary to ensure that the system does not introduce competitive distortions. Rationale Most DIS with ex-ante funding maintain one deposit insurance fund. However, a separate deposit insurance funds can be established when there are major differences between the risk profile of different types of institutions. If separate funds approach is adopted, it is important to ensure that the integrity of the funds are maintained and that distinctions among the institutions and their funds are real and do not contribute to competitive distortions. VI. Determining the Optimal Size of a Deposit Insurance Reserve (4)

16. Suggested Guidance #10 The deposit insurer should ensure that its funds are well managed and readily available to cover losses as they arise. This can be accomplished by implementing appropriate investment policies and procedures, and by instituting sound internal controls, risk mitigating practices, disclosure and reporting systems. Rationale It is important to have clear oversight by DIS over the funding process and investment policy. This policy would set out the goals and objectives of funding management and should also include provisions for an internal audit process for monitoring investment policies. Investment policies should be made publicly available in annual reports or other materials. VII. Management of Deposit Insurance Funds

17. Suggested Guidance #11 The accountability and integrity of a DIS can be enhanced by ensuring that the system is transparent and information on its funding is disclosed in a timely, consistent and accurate basis. Nevertheless, policymakers need to determine the appropriate balance between the desire to promote accountability and sound management through disclosure and the need to ensure confidentiality and financial system stability. Rationale Ensuring that the DIS is transparent and disclosing information in a timely, consistent and accurate manner can enhance the accountability and integrity of the deposit insurance system. But, certain forms of disclosure can have negative consequences such the disclosure of member-specific information to the public. VIII. Transparency and Disclosure applied to Funding

18. Suggested Guidance #12 The deposit insurer may not have sufficient resources to handle all situations. Ways of obtaining supplementary funding to handle contingencies should be considered. Rationale There are a number of alternative funding options potential for improving the situation of depositors and the deposit insurance agency such as reinsurance through catastrophe bonds, credit derivatives, cross-guarantees among member banks and the setting up of multi-jurisdictional funds for insurers. IX. Other Types of Funding Arrangements available to Deposit Insurers

19. X. Conclusions • A well-designed deposit insurance system can make an important contribution to the integrity of a country’s financial system, thereby promoting financial and economic stability. • In order to meet its objectives of protecting small depositors and maintaining public confidence in the ability of the deposit insurance system to meet its commitments adequate funding arrangements must be in place. • Ex ante approach is preferable in most circumstances particularly for newly established systems.

20. Thank you for your kind attention!