Executive Summary
This report focuses on the role of deposit insurance in the financial system. A deposit insurance scheme is a strategy whereby depositors are paid their money by the government or the organization that runs the scheme if a financial institution becomes insolvent (Gracia, 2002, 12). Using secondary data from Australia, the United Kingdom and New Zealand, the research findings indicate that deposit insurance has the following benefits. It promotes stability, ensures confidence and promotes growth in the financial industry. The negative effects associated with it include high levels of regulation, high costs of implementation and the problem of moral hazard. It is thus recommended that deposit insurance schemes be modified from time to time to meet the expectations of all stakeholders.
Introduction
Deposit insurance is a strategy used by most governments or central banks “to protect the bank depositors either in part or in full from the losses caused by a bank’s inability to pay its debts when due” (Gracia, 2002, 13). It is an integral part of a country’s financial system that acts as a safety net and also enhance overall financial stability in the economy. The compensations are usually paid by the government or an independent organization that offers deposit insurance services to the financial institutions (Gracia, 2002, 23). While this strategy is expected to enhance stability and confidence in the banking industry, other players in the financial markets resist it on the ground that it promotes the risk of moral hazard. This paper focuses on the use of deposit insurance in Australia as well as the United Kingdom and New Zealand. It particularly highlights the features of deposit insurance, why it was introduced and its effects on the Australian economy.
Reasons for Introducing Deposit Insurance in Australia
The plan to implement a deposit insurance scheme in Australia dates back to the 1997’s Wallis inquiry. The 1997 initiatives were later revived in 2001 following the collapse of HIH insurance and the subsequent losses associated with it (Calmiris, 2009, pp. 44-75). In response to the 2008/2009 great financial crisis, the government of Australia decided to implement the deposit guarantee scheme to cushion investors from the potential risks associated with the collapse of financial institutions. The specific reasons leading to the implementation of the deposit insurance scheme in Australia are as follows.
First, the scheme was meant to protect the citizens from losing their money or investments in the event of a bank collapse. Even though most financial institutions in Australia appeared to be financially healthy during the great financial crisis, the government felt that it was necessary to be prepared for the worst (Calmiris, 2009, pp. 44-75). This involved implementing the deposit insurance scheme so that Australians could get access to their deposits in case their banks collapsed.
Second, the move was meant to put Australia at par with its peers within the OECD. Before the introduction of the scheme, Australia was among the only two countries within the OCED that lacked a government guarantee over money deposited in its financial institutions (Calmiris, 2009, pp. 44-75). New Zealand was the other OCED member country that never had the deposit insurance scheme.
Third, the initiative to provide guarantees over deposits was motivated by the need to restore confidence in the country’s financial system during and after the great financial crisis. Due to the contagion effect, most Australians felt that the crisis would snowball into their economy thereby leading to the collapse of banks and insurance companies (Calmiris, 2009, pp. 44-75). Therefore, the government found it important to restore confidence in the financial sector by guaranteeing citizens of their deposits.
Fourth, the deposit insurance scheme was meant to promote growth in the financial sector and to boost overall economic activity, especially after the financial crisis. The idea here was that with great confidence in the financial system, more citizens would save through banks. Such savings would then be used to create credit through a fractional reserve system (Calmiris, 2009, pp. 44-75). The credit facilities thus would provide capital for investments in the economy.
Due to the asymmetry of information regarding the stability of various banks in Australia, it was important to introduce the deposit insurance scheme (Calmiris, 2009, pp. 44-75). This is since the scheme would make all banks participating in its safe haven for the depositors’ money. Hence citizens who had difficulty in identifying risky banking institutions had little to worry about while depositing their money.
Finally, the deposit insurance system was implemented as a firewall that would prevent shocks attributed to the financial sector from adversely affecting other economic agents such as households and firms. The move was meant to ensure stability in the economy.
Current Position of the Deposit Insurance
The deposit insurance scheme in Australia has been in operation since its official inception in October 2008. The scheme that has since been implemented as a regulatory measure; requires the authorized deposit institutions to participate in it. The deposit guarantee services are provided by the government in conjunction with the deposit institutions and the regulators of the financial system (Calmiris, 2009, pp. 44-75). As a stabilization strategy, depositors are assured of recouping their investments if a banking institution covered by the government deposit guarantee becomes insolvent.
The financial institutions are covered for deposits of up to one million dollars per bank (Calmiris, 2009, pp. 44-75). In some instances, the government still provides cover for deposit balances above the one-million-dollar cap. However, such special arrangements are made at a significant cost. Thus, not all institutions can participate in them.
Foreign banks operating in Australia are also allowed to participate in the scheme since they hold significant deposits belonging to Australians. The foreign banks are allowed to access the deposit insurance services for “short-term wholesale funds raised from Australian residents at the same premium that applies to other authorized deposit institutions” (Calmiris, 2009, pp. 44-75).
Currently, the scheme provides a guarantee to over fifteen million deposit accounts in Australia. Deposits well above 800 billion dollars and fundraising facilities over 1.2 trillion held by various institutions are covered by deposit insurance (Calmiris, 2009, pp. 44-75).
Adverse Effects of the Deposit Guarantee
There are three major consequences of the deposit guarantee provided by the government. The current debate on whether the guarantee is good or bad for the economy is partly attributed to the consequences of deposit insurance which are as follows. To begin with, a deposit guarantee leads to the problem of moral hazard. A moral hazard is “a situation whereby a party insulated from a risk behaves differently from how it would behave if it were fully exposed to the risk” (Calmiris, 2009, pp. 44-75). In the absence of deposit insurance, the competition for deposits among banks would be high as depositors go for safe banks. This would thus promote efficiency in the financial system. However, with the introduction of deposit insurance, banks are encouraged to take high risks since depositors are guaranteed their money. Taking such high risks is a threat to the financial system. This means that deposit insurance will be more destabilizing than stabilizing in the long run.
In response to the problem of moral hazard, the quality of assets, the risk taking behaviour and management practices of banks are closely monitored by the regulators of the financial industry. However, the high level of regulation has turned out to be costly to the banks since it restricts their operations (Calmiris, 2009, pp. 44-75). The regulators also require the banks to maintain a substantial amount of capital to enhance the confidence of the banks’ stockholders. However, some banks especially the small ones find it difficult to hold significant capital due to their limited financial resources.
The second effect of the deposit guarantee is its cost (Calmiris, 2009, pp. 44-75). The fees charged especially for deposit balances over one million dollars are very high. This has not only limited the use of the scheme but has also led to its opposition. Finally, there has been a misunderstanding regarding the role of deposit guarantee. Some financial institutions and depositors are yet to understand the concept, its benefits and costs.
Deposit Insurance in the United Kingdom
The United Kingdom is one of the developed countries that use the concept of deposit insurance to ensure stability in their financial systems. In the UK, deposit insurance has been implemented as a compensation scheme and its features are as follows. The scheme currently provides full compensation for deposits up to a maximum of 85,000 pounds per depositor per financial institution (Dermirguc-Kunt and Laeven, 2009, pp. 403-501). The compensation is available to any individual keeping money in any authorized UK based financial institution such as banks, credit unions or building societies. Thus, if the financial institutions become insolvent, the depositors are eligible for the full compensation upon making a formal application.
Currently, depositors receive their initial compensations within seven days. The rest of their money is normally received in the next twenty days. Joint account holders are each eligible for the compensations (Dermirguc-Kunt and Laeven, 2009, pp. 403-501). Thus, if two people jointly hold an account, compensation of up to 170,000 pounds will be offered.
The money owed to the bank by the depositors at the time of its collapse is not written off. Such debts remain and must be paid by the depositors. In the same spirit, any money owed to the depositors by the bank is normally paid in its full amount.
Savers are entitled to only one instance of compensation per authorized financial institution. Thus, depositors with more than one bank account with a bank can not access multiple compensations (Dermirguc-Kunt and Laeven, 2009, pp. 403-501). However, if the depositor’s bank has separate authorization, the depositor will be eligible for compensation from each bank even if all the banks are owned by one company.
Finally, small businesses are also covered by the scheme provided they meet the following requirements. Their annual turnover must not exceed 6.5 million pounds, their balance sheet should not be more than 3.26 million pounds and their employees should be less than fifty. Big businesses are however not covered under the compensation plan.
Deposit Insurance in New Zealand
In New Zealand, the deposit insurance scheme was implemented in the form of a retail deposit guarantee. The scheme was meant to enhance confidence in the country’s financial system during the global financial crisis. Retail deposit insurance offers compensation for retail deposits up to a maximum of 522,700 US dollars (Dermirguc-Kunt and Laeven, 2009, pp. 403-501). The compensations are provided for deposits that are held in approved financial institutions. The scheme was initially planned to last for two years but has since been extended to December 31st, 2011. Possibilities of making changes to the terms and conditions of the scheme were also provided for in the initial plan.
In order to implement the scheme, the government of New Zealand entered into agreements with various financial institutions such as banks and building societies. The agreements are referred to as Crown deeds. The deeds guarantee the financial institutions compensation for their retail deposit holders (Dermirguc-Kunt and Laeven, 2009, pp. 403-501). This means that if a financial institution that has signed the deed becomes insolvent, the Crown pays the eligible depositors.
Relevance of Deposit Insurance in its Current Form
As the world recovers from the adverse effects of the last financial crisis, some players in the Australian financial industry feel that deposit insurance is no longer necessary. Some believe that deposit insurance should at least be modified as the global financial system improves. The basis of these varied opinions boils down to the benefits and costs of deposit insurance. As discussed earlier, deposit insurance leads to the problem of moral hazard (Gracia, 2002, 72). Correcting such a problem involves intense regulation which limits the operations of financial institutions. Besides, the cost of implementing the scheme is high. It is against this backdrop that some players believe that deposit insurance should be eliminated now that the financial system is more stable. Those who support amendments to the scheme believe in the scheme’s long term role in ensuring stability, confidence and growth in the financial sector (Gracia, 2002, 73). Thus, any amendments to the scheme will only make it more beneficial. As pointed out earlier, there are still a lot of misunderstandings concerning the role of deposit insurance. Thus, some people oppose it for lack of knowledge of its importance. The reality is that deposit insurance is very important in every financial system. Any amendments to its features should focus on improving its benefits.
Conclusion
Deposit insurance is a strategy used in most financial industries to ensure stability, confidence, and growth. It particularly offers a guarantee for compensations to depositors if a financial institution collapse (Gracia, 2002, 24). Australia has joined the rest of the world in providing deposit guarantees to depositors in order to maintain a sound financial system. Despite the benefits associated with it, deposit insurance has also been considered an inefficient strategy due to its limitations. The most prominent of its limitations include the problem of moral hazard, high costs and high regulation. To maximize the benefits of deposit insurance, the design and implementation process should consider the interests of all parties. This will not only enhance its acceptability but will also increase its benefits.
References
Calmiris, C., 2009. Banking Crisis and the Rules of the Game. Asian-Pacific Journal of Risk and Insurance. 12(1), pp. 44-75.
Dermirguc-Kunt, A. and Laeven, L., 2009. Deposit Insurance around the World: Issues of Design and Implementation. Asian-Pacific Journal of Risk and Insurance, 1(2), pp.403-501.
Gracia, G., 2002. Deposit Insurance: Actual and Good Practice. New York: International Monetary Fund.