During the global financial crises, increasing competition and instability in global financial markets, one of the major problems for many countries is maintaining a financially sustainable system that also relates to the banking sector. There is no single solution to this problem. The search for effective mechanisms, appropriate for individual country, requires a careful analysis of the economic situation in the country and search specific methods. However, international experience shows that deposit insurance is an effective method of maintaining stability in the banking sector, strengthening the public confidence in the banking and financial system.
Deposit insurance is a system established to protect depositors against the loss of their insured deposits in the event that a bank is unable to meet its obligations to the depositors. Deposit insurer refers to the specific legal entity responsible for providing deposit insurance, deposit guarantees or similar deposit protection arrangements. Deposit insurance system refers to the deposit insurer and its relationships with the financial safety-net participants that support deposit insurance functions and resolution processes. 1
The decision to create the system of banking deposits protection, many countries have adopted in the crisis of the banking systems and bankruptcies of many banks.
The first deposit insurance system was created in the United States. First thoughts on protection of deposits has appeared in 60s of the 19 century and represented the idea of creating a special fund to pay compensation to victim depositors. Real actions were taken in 1933 when Congress signed the Act to create the Federal Deposit Insurance Corporation (FDIC) and created a temporary federal deposit insurance fund. These measures were necessary because the situation in the banking system has deteriorated significantly during the Great Depression, due bankruptcies most banks paying compensation was not possible, which negatively affected the attitude of the population towards the banking system and their level of trust.
The next in the world, deposit insurance was introduced in India. In 1962 was created the Deposit Insurance Corporation (DIC) after the bankruptcy of the two largest banks in the country Laxmi Bank Ltd. and Palai Central Bank Ltd. In 1978, DIC merged with the Credit Guarantee Corporation of India and the present Deposit Insurance and Credit Guarantee Corporation was created (DICGC).
In 1994, the establishment of a deposit insurance system became compulsory in the EU. According to the Directive on Deposit schemes each EU country should have one or more deposit insurance and no financial institution should not take deposits, did not take place in such a system.
Until the first half of 90s the system of deposit protection was implemented mainly in countries with developed economies, however since the mid-1990s developing countries also began to introduce this system.
In 2002, 25 European entities have established the European forum of deposits insurers (EFDI), which in five years became an international non-profit organization whose members today are 57 organizations.
May 6, 2002 was established a non-profit International Association of Deposit Insurers (IADI), which included 64 organizations.
There are three types of deposit protection system organization:
1. System operating in accordance with the rules of insurance activities;
3. Mixed system that includes elements of the above two systems.
Basically, the bank deposits insurance system is created according to the following scheme:
-creates the legislative framework necessary for the functioning of the system;
-the insurance system mainly involves all banks;
-creates a public or mixed organization to regulate the activities of insurance system;
-envisages the active participation of the state;
-the system is financed by the state and contributions of the banks themselves;
- set the coverage limit of insured payments from the calculation of per depositor or per deposit;
-fixed rates of contributions determined as a percentage of the total amount of bank deposits.
When you create a deposit protection system one of the most important issues is the definition of so-called incentive mechanism. Each participant of bank deposit insurance system must have a certain benefits from participation in the system. For example, the incentive for depositors may be the preservation and enhancement of their funds, for the state incentive is the provision of stability in the banking sector and increase confidence of the population to it.
Next, examine the main element of deposit protection system, which is the object of insurance-the deposits.
Deposit operations are banks’ operations on attraction of funds of legal entities and individuals in deposits, or on certain time, or on demand. Usually deposit transactions are the main share of bank liabilities.
As subjects of deposit operations can act state enterprises, institutions and organizations, joint stock companies, mixed enterprises involving foreign capital, financial institutions, insurance companies, investment and trust companies and foundations, private individuals, and banks and other lending institutions.
Objects of deposit operations are deposits – the amount of funds that subjects of deposit operations pay into bank, for some time deposited in bank accounts under the applicable procedure of banking operations. 2
In terms deposits are divided into two groups:
1. Demand deposits;
2. Time deposits.
Demand deposits – funds in current, savings accounts associated with commission payments or target use.
Operations in these accounts are conducted frequently, so operating costs are usually higher than on time deposits, but because on these accounts banks pay low interest or no interest is paid (then the customers can be provided with various kinds of benefits), these resources’ price for the bank is relatively low. At the same time, it is the least stable part of the resources, so banks must have on them a higher operational reserve to maintain liquidity. Therefore, an optimum proportion of these funds in resources of the bank are up to 30-36%.
Time deposits are funds deposited in the bank on fixed term of the contract. On them to owners usually higher interest is paid, than on demand deposits, and, as a rule, there are restrictions on early withdrawal, and in some cases and on deposit replenishment.
Operational expenses of banks on time deposits, as well as rates of reservation, usual more low, than on demand deposits, but payments on percent it is considerable above, therefore they are not always favorable to banks. But banks are interested in attraction of time deposits as they can be used for long-term investments.
Time deposits are subdivided - on the conditional (the deposit is kept before an event), with prior notice about the withdrawal of funds (when the customer is within a predetermined timeframe must apply for withdrawal) and actually time deposits.
Actually time deposits on periods of storage are subdivided into deposits with term:
-deposits with the term up to 3 months;
-deposits with the term from 3 to 6 months;
-deposits with the term from 6 to 9 months;
-deposits with the term from 9 to 12 months;
-deposits with the term more than 12 months.
The funds of depositors in the bank charged on current, savings and deposit accounts. Balances in such accounts are summarized and given in the balance sheet the single balance. Attracted funds of depositors on deposits are grouped by term.
When the depositor pays funds on deposit, it is the deposit agreement. For each type of deposit is a separate type of the deposit agreement. The agreement is made in two copies, one remains with the depositor and the other is kept in the bank. It includes the deposit amount, its duration, interest that is payable to the depositor, its rights and responsibilities, as well as responsibility of parties for compliance with the terms of the contract and the obligations and rights of the bank.
Commercial banks in the conditions of competition in the market of credit resources need to constantly take care of as a quantitative and qualitative improvement of their deposits. They use different methods for this (interest rate, various services and benefits to depositors). The procedure for conducting deposit operations is regulated by internal documents of the bank. At the same time, all banks comply with some basic principles of the organization of deposit operations. They are as follows:
-deposit operations should contribute to profit or to create conditions for profit in the future;
-deposit operations should be diverse and conducted with various subjects;
-special attention in the organization of deposit operations should be given to time deposits;
-the relationship and coherency between deposit operations and credit operations on the timing and amounts of deposits and credit investments should be provided;
-in organizing deposit and credit operations, the bank should seek to minimize their available resources;
-the bank should take measures to develop banking services that are promoting attraction of deposits.
For passive operations, particularly on deposits, banks are obliged to establish required reserves.
Required reserves are the amount of money that commercial banks are required to deposit in the National Bank of Kyrgyz Republic on the conditions established by National Bank. The size of required reserves is established by the Board of the National Bank in percentage of the calculation base. Calculation base is national currency and foreign exchange liabilities of the bank accounted for its deposits and other accounts. The list and the currency structure of the liabilities included in the calculation base approved by the Board of the National Bank. Reserve assets are the amount of cash balances in the bank ATMs in national currency and funds on the correspondent account in the National Bank. Required reserves are one of the instruments of monetary policy used by the National Bank as the regulator of monetary aggregates, bank credits and demand for liquidity. The size of the required reserves can be changed in order to monetary policy. For different categories of liabilities that are included in the calculation base can be set different percentage values. Depositing of the required reserves is carried out in the form of placement of funds on correspondent account in the National Bank. 3
The Board of the National Bank established the following sizes of required reserves for liabilities, included into calculation base of required reserves:4
a) on liabilities in national currency - at the level of 4.0 per cent of the amount included in the calculation base of liabilities in national currency;
b)for liabilities in AMD, BYR, KZT, Chinese Yuan Renminbi, Russian ruble - at the level of 4.0 per cent of the amount included in the calculation base of liabilities in AMD, BYR, KZT, Chinese Yuan Renminbi and the Russian ruble;
c) on liabilities in foreign currencies, except for those specified in sub-paragraph (b) of this paragraph - at the level of 12.0 per cent of the amount included in the calculation base of liabilities in these foreign currency.
In most countries, required and voluntary (working) reserves of commercial banks kept in the Central Bank on the same interest-free account - mainly on correspondent or reserve. In some countries, commercial banks are allowed to temporarily use part of these reserves to conduct credit and other active operations.
Many western economists recommend that central banks pay interest on required reserves of commercial banks, to stimulate the last in a timely manner and to adequately comply with the established reserve requirements. Although this increases operating costs of central banks, in some countries (Sweden, Spain, Italy, Finland) on the part of the reserves accrue interest.
So, we can say that deposits for banks are one of the most important and at the same time one of the cheapest resources. By increasing the amount of deposits in the resource base, reduced interest expenses of the bank, but it also reduces liquidity.
The main principles of deposit protection system functioning are:
-mandatory participation in the deposit insurance system;
-reduce the risks of adverse consequences for depositors when banks fail to meet their obligations;
-transparency of the deposit insurance system
Deposit protection systems can be classified by the following features: 5
1. According to the methods of the insurance systems organization:
-system of the guarantees that are not expressed directly
The first type is characterized statutory procedure of compensation of losses to depositors in case of bankruptcy of the bank. It promotes the confidence of depositors in the safety of their money, as the functioning of the system orderly and predictable.
The second type is characterized by the absence of such a procedure, but the government guarantees the funds invested in the banks. This type of system is typical for countries with high trust of citizens to the state, as is the ability to get a refund will depend on the adopted state bodies’ decisions.
2. According to the organization of participation of banks in insurance system:
-mandatory participation system;
-voluntary participation system
In the system with the mandatory participation of almost all banks become members of the insurance system that gives equal protection to clients of different banks. The disadvantage of this system is the lack of desire from customers to search and choose a reliable bank.
In a system with voluntary participation, banks take the decision to join the insurance system by them. In this case, banks that have not entered into the system become less competitive. However, despite the voluntary participation, the government can make some restrictions in the activities of such banks, thereby encouraging them to join the system.
3. The size of guarantees:
The first kind of system makes payments on all deposits.
The second type of system provides only partial coverage of customer deposits. Here the advantage goes to the small investors - depositors who are less-informed about the situation on the market. At the same time motivation of large depositors to choose the more reliable bank increases.
The third type is a kind of subspecies of a limited system. Here it is possible to extend the object of insurance in times of crisis the banking system.
4. According to the degree of state involvement:
The public system stipulates compulsory insurance of deposits. Organization dedicated to insurance, functioning at the expense of the state and contributions of banks, while acting on a nonprofit basis.
In private systems, the government does not interfere in the activities of organizations engaged in insurance of deposits. In this case, the job of insurance companies is carried out through contributions from the banks.
In mixed systems of deposit insurance, the resources of the insurance organizations are formed at the expense of the state, and at the expense of banks.
5. According the organization of financing the payments or the method of storage of insurance fund:
Deposit insurance system with the financing involves the establishment of a special fund from the regular contributions of banks for the payment of insurance claims.
In the deposit insurance system without financing the necessary funds for compensation are generated only if necessary.
Methods of organizing deposit protection system can be roughly divided into several groups:6
1) expressed rejection of the deposit protection;
2) certain law, the priority of depositors over other financial requests when the liquidation of the bank in place of the guaranteed amount on deposits;
These methods operate in New Zealand and Australia respectively. Their disadvantage is that in each case it is difficult to assess the quality of bank assets, which weakens market discipline. As in the banking sector sometimes occurs a bank run, regulators can’t rely on market discipline. In this case, the lender of last resort will face significant challenges in terms of supporting the banking system.
When using 4 and 6 of the methods the government may explicitly or implicitly to protect all deposits. The disadvantage of using these methods that can be violated moral principles for the whole system. For example, based on the provided protection, banks can increase the share of risky operations. Also, in the case of systemic crises 6 method is the most used.
The majority of governments use 5 a method approved by the International Monetary Fund. It differs in that it has a size limit of the sum insured. The use of this option usually is paired with coordinated systems of internal control, regulatory and competitive discipline that substantially maintains the stability in the banking sector and reduces the number of possible crises. Usually under protection fall certain categories of investors – the owners of small deposits. The operation of the system of deposit protection has clear legislation and reflected in all relevant public documents.
Thus, after analyzing information concerning system of deposits protection, we can conclude that the introduction of such systems will allow installing and providing stability in the financial system of the country. The process of creation the deposit insurance system should be guided by the relevant principles, also we should consider the types of systems, their characteristics and international experience. The optimal structure of the system of deposit protection should correctly reflect those potential problems that can arise during its development and application. The introduction of the deposit protection system in general has a positive impact on the banking system, but in the course of its implementation may be some issues related to the problems of moral hazard, adverse selection and asymmetric information.
Moral hazard problems arise when investors, based on the protection provided by the state, not diversify risks and choosing banks to place their money with less attention and care. Banks are also based on the unlikelihood of mass withdrawals of funds by depositors can increase risky operations or take additional risks, reduce the amount of capital and reserves, which they should have in the event of crises. All this may cause the liability for compensation of lost funds of depositors will have to take the state, what has happened in many countries and often were the cause of economic crises.
In cases when the system of deposit protection involves voluntary participation and the amount of insurance fee is not adjusted to risk, which assumes the fund, there is reverse the selection, what attracts weak banks and repels strong banks. From the system with the reverse selection powerful members of the banking sector would prefer to go out that will entail an increase in the size of contributions. This measure will force to go out the remaining strong banks. As a result, there will be only weak market participants. It will negatively affect the solvency of the fund and the situation in the banking system as a whole.
Asymmetric information arises when one party, usually the small investors, do not have sufficient information for making decisions compared to bankers or by the more informed party, usually the larger depositors or investors.