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p. 35 of 58 BACK | NEXT Purpose and Structure of the Toolkit Part One: Introduction and Overview Part Two: Preconditions and Infrastructure for Financial Sector Development Part Three: Financial Regulation and Supervision I. Financial Stability, Development and Institutional Design II. Financial Regulation: General Principles III. Financial Regulatory Structure IV. Banking Regulation V. Bank Insolvency and Depositor Protection A. Lender of Last Resort B. Depositor Protection Schemes C. Deposit Insurance: International Standards D. Bank Insolvency VI. Securities and Derivatives Regulation VII. Insurance and Pensions Regulation VIII. Regulation of Financial Conglomerates Part Four: Regional Financial Integration Part Five: ADB's Intervention in the Financial Sector Bibliography Glossary and List of Abbreviations Acknowledgements

Financial Sector Legal and Regulatory Toolkit : Part Three: Financial Regulation and Supervision : V. Bank Insolvency and Depositor Protection

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B. Depositor Protection Schemes

The next mechanism of immediate crisis resolution is the idea that some sort of depositor protection scheme can be put in place to support confidence in times of crisis. In recent years, increasing numbers of jurisdictions have been turning to these systems, especially deposit insurance.

In analyzing depositor protection schemes, it is first necessary to place them in the appropriate context, namely, as one aspect of an overall financial safety net designed to prevent systemic risk and maintain financial stability. In general terms, the financial safety net has developed out of specific regulatory objectives to form the traditional regulatory and supervisory process. In this process, the key authorities and their functions can be categorized as follows:

1. monetary policy authorities
2. supervisory authorities
3. lender of last resort
4. deposit insurance authorities
5. insolvency authorities
6. criminal authorities
7. the legislature and government (policy)
8. the judicial system (dispute resolution, contract enforcement and judicial review)
9. international commitments (e.g., WTO/GATS)

There are three interconnected legal and policy issues that are fundamental for understanding deposit insurance from a legal point of view:

• the mandatory nature of deposit insurance, as opposed to the contingent nature of the LoLR role of the central bank;
• the difference between explicit and implicit deposit insurance; and
• the status of preferred creditors that insured depositors have under an explicit deposit guarantee scheme.

Deposit insurance provides a non-contingent guarantee on certain deposits. The LoLR, on the other hand, is contingent. The injection of liquidity in times of crises is not mandatory, but discretionary, i.e., subject to the discretion of the central bank authority. Thus, explicit deposit insurance provides legal certainty regarding the coverage of insured depositors. There is always a degree of uncertainty (some economists refer to it as "constructive ambiguity") regarding the provision of emergency liquidity assistance by the central bank.

It should also be pointed out that while explicit deposit insurance protects mainly the depositors, the LoLR protects mainly the financial system (systemic considerations).

To minimize the risk of moral hazard, it is important to delineate what each institutional arrangement can do and what it cannot or should not do. Explicit deposit insurance can protect insured depositors, but it cannot—and should not—protect other depositors or creditors, shareholders, or managers. Explicit deposit insurance cannot protect the banks, because it can only be activated once a bank is closed. The LoLR "can provide emergency liquidity—quick cash up front—over a short period of time, when no other sources of funding are readily available. What the central bank should not do is lend over an extended period of time nor commit funds without the explicit approval of the fiscal authority." (Lastra, 1999)

As the starting point, any form of depositor protection can either be implicit or explicit. In addition, it is clearly possible for any jurisdiction to have no such system in place at all; while some suggest that no system is in fact an implicit government guarantee, it is possible (though certainly not politically easy) not to provide government support at all and on occasion governments have managed to stand aside. In most cases, however, no deposit insurance system does in fact imply an implicit government guarantee, at least for depositors of the largest financial institutions. While an implicit guarantee certainly raises many issues, these are typically political rather than legal.

Explicit systems typically take one of two forms: (i) an explicit blanket guarantee of all deposits or (ii) an explicit, limited-coverage system of deposit insurance. Each raises a variety of legal issues.

Explicit deposit insurance, such as the creation of a deposit guarantee scheme by law, with rules with regard to the extent of the "insurance" or protection, the rules of the scheme, and the type of deposits/depositors protected can be a useful instrument of protective bank regulation. Indeed, explicit deposit insurance has traditionally served two purposes: consumer protection and the prevention of bank runs. A third rationale of explicit deposit insurance is that it allows the public authorities to close banks more easily, as it becomes politically acceptable to liquidate insolvent institutions, in the knowledge that less unsophisticated depositors are protected.

Under an explicit deposit guarantee scheme, depositors are only paid once the bank is closed and liquidated. Thus, there can be no deposit insurance if the bank remains open. Therefore, explicit deposit insurance presupposes that a bank has failed and, hence, it is not compatible with the "too big to fail" doctrine.

Implicit deposit insurance, as opposed to explicit deposit insurance, is a "blanket guarantee" for all kinds of depositors (insured and uninsured), other creditors, shareholders, and even managers. Implicit deposit insurance often presupposes that the bank remains in business (either because it is "too big to fail" or because it is politically difficult to close the bank), thus creating pervasive moral hazard incentives. While explicit deposit insurance is applied ex post (following the closure of a bank), implicit deposit insurance is often applied while a bank is still in operation—the government steps in to prop up a bank instead of closing the bank.

Explicit deposit insurance inflicts only very limited damage upon taxpayers, and, depending on the funding of the scheme, there may be no damage at all. However, implicit deposit insurance has the potential of shifting the burden onto taxpayers, since rescue packages tend to be financed by the government. The use of rescue packages results not only in moral hazard considerations, but may also affect competition, especially if a "too big to fail" doctrine is applied.

An explicit blanket guarantee can take either a formal legal form (Japan, Mexico, Taiwan, Turkey) or simply be a government pronouncement or policy (Korea 1997-2000, Malaysia, Sweden 1992-1996, Thailand). Either will likely be sufficiently clear and robust for purposes of confidence; the difficulty arises if the government decides to eliminate the guarantee and move to an explicit, limited-coverage system of deposit insurance. Japan, the Republic of Korea, and Sweden appear to have made successful transitions from blanket guarantees to limited, explicit systems.

Explicit deposit insurance is a guarantee limited to one type of "preferred creditors," i.e., insured depositors. Under explicit deposit insurance, uninsured depositors, other creditors, shareholders, and managers are not protected. Therefore, explicit deposit insurance is more compatible with market discipline, as uninsured depositors and other creditors have an interest in monitoring the solvency of the bank while still in operation.

Explicit deposit insurance, by limiting the protection of "insured depositors," exposes uninsured depositors, general creditors, subordinated debt holders, shareholders, and management to increased risk, thereby encouraging them to monitor and limit the riskiness of the bank. These incentives are very important, particularly in the case of shareholders, whose limited liability renders them more prone to lend on a high risk/high return basis, while restricting their own exposure through high leverage. In the absence of open bank assistance, management will also be inclined to run the institution in a prudent manner, or risk being removed from office. Explicit deposit insurance must be set at a level that enables national authorities to accept the political consequences of bank liquidations.

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