Crisis Talk - The World Bank Group

Deposit Insurance, Blanket Guarantees and Exit Strategies

The World Bank held a discussion yesterday on the role of extraordinary deposit insurance schemes in the crisis. Fred Carns from the FDIC and David Walker from the CDIC (Canada) outlined the lessons learned, measures taken, and future policy recommendations for the world's deposit insurance schemes.

The main crisis driven deposit insurance arrangements include:

• More than one-third of deposit insurance programs around the world have adopted some form of enhanced deposit insurance protection during the crisis.
• Less than 20 percent of deposit insurance jurisdictions have provided blanket guarantees. Yet this minority is significant, and includes the United States. Some schemes apply only to selected categories of deposits, while a handful take the form of political promises as opposed to changes in law or regulations.
• Among jurisdictions that did not provide blanket guarantees but raised their coverage limits, the extent of the increases varies widely.

Blanket Guarantees: What next?

Editor’s note: The World Bank Group has just released the fourth paper in its Crisis Response series, which aims to chart a path out of the crisis. This current release discusses deposit insurance and government guarantees of other bank liabilities, and possible strategies for winding down the blanket guarantees issued during the crisis.

The expansion of deposit insurance and introduction of debt guarantees have played a crucial role in containing the financial crisis while giving governments time to develop suitable policy responses. But these measures do not address the root causes of the crisis, and they lead to competitive distortions, moral hazard, and large fiscal contingent liabilities. Rolling them back is likely to require an internationally coordinated effort—and an answer to the important question, “exit to what?”

To download a PDF of the paper, please click here.

The Sacred Cows of Capitalism, Alive and Kicking

Wounded perhaps, but the sacred cows of capitalism are alive and kicking, according to a new World Bank working paper by Asli Demirguc-Kunt and Luis Serven. The authors of Are All the Sacred Cows Dead? argue that "the 'sacred cows' of financial and macro policies are very much alive...the on-going crisis does not simply reflect a failure of free markets, but a reaction of market participants to distorted incentives."

Demirguc-Kunt and Serven, however, aren't just adding another paper to the now large pile that do a post-mortem on the origins of the financial crisis. The approach is much more prospective than that. How are regulators and central bankers in emerging markets to deal with banking systems and financial markets facing severe stress? It's more of this type of analysis that's needed right at the moment.

On blanket guarantees (compare this to a recent post from Thorsten Beck):

It must be recognized that the short-term benefits of guarantees will vary with the fiscal strength of the guaranteeing government. To hasten the end of an insolvency driven banking crisis and to constrain the spread of insolvencies in the short term, the government must manifest a substantial capacity for absorbing losses. This is not a luxury most countries can afford since most governments do not have the required fiscal capacity. Depending on the depth of the systemic insolvency such support may not even halt the spread of crisis and delay healthy adjustments.

On government ownership of banks:

Given the extent to which lending policies are politicized, it is not surprising that state ownership appears to heighten the risk of crises instead of reducing it. If anything, research suggests that greater state ownership is associated with various measures of financial instability, including a greater probability of banking crises.

On market discipline and Basel II:

Many interpreted the crisis as a vivid example of market failure, evidence that there is no such thing as market discipline, reinforcing calls for stronger regulations through improvements in Basel II accord. But the crisis also spawned a growing argument about the role Basel I accord may have played in causing the crisis. Indeed, it is no secret that Basel I contributed to the growth in securitization by assigning lower capital charges and thus giving incentives to institutions to move their assets into off balance-sheet securitization vehicles. While advocates claimed that Basel II, had it been implemented earlier, could have lessened or prevented the turmoil, critics of the Basel approach to capital regulation pointed out that the crisis has simply reconfirmed fundamental flaws that have been evident in this approach.

>> Download a PDF of Are All the Sacred Cows Dead?

Is Deposit Insurance Really the Solution to Depositors’ Worries?

Deposit insurance is an attractive tool for politicians, especially in crises such as this one. Announcing (unlimited) coverage of deposits in the banking system can prevent depositors from bank runs. And as long as the authorities do not have to make good on their promise, it is also a cheap tool. By now, however, most economists are well aware of the moral hazard effects of generous deposit insurance, a product of reduced market discipline. The result? Aggressive and imprudent risk taking. But considering recent events in Russia, one should be careful about believing blindly in the confidence-creating effect of deposit insurance either.

Some months ago, a small Russian bank called Capital Credit simply refused routine withdrawals by their customers, thus clearly signaling its illiquidity (which normally comes after insolvency!). But the Central Bank of Russia (which is also responsible for bank supervision) did not take any action for several weeks despite heavy protests by depositors. Only when depositors threatened to demonstrate in front of the Central Bank did bank supervisors finally withdrew Capital Credit’s license, thus allowing depositors to start the process of recovering at least part of their savings from the deposit insurance.

The result: despite an explicit deposit insurance scheme and despite the government’s assurance that all deposits would be secure, a loss of trust and confidence in the banking system occurred. As long as bank supervisors are not strong enough to intervene into failing banks, deposit insurance schemes cannot help conserve or restore confidence in the banking system.