Fair Premium Rate of the Deposit Insurance System based on Banks’ Creditworthiness | Asian Development Bank

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Fair Premium Rate of the Deposit Insurance System based on Banks’ Creditworthiness

Publication | July 2017
Fair Premium Rate of the Deposit Insurance System based on Banks’ Creditworthiness

Deposit insurance is a key element in modern banking, as it guarantees the safety of deposits at financial institutions. But premiums should vary based on the institutions’ creditworthiness.

Deposit insurance is a key element in modern banking, as it guarantees the financial safety of deposits at depository financial institutions. It is necessary to have at least a dual fair premium rate system based on the creditworthiness of financial institutions, as a singular premium system for all banks will have a moral hazard. In this paper, we develop a theoretical as well as an empirical model for calculating dual fair premium rates.

Our definition of a fair premium rate is a rate that can cover the operational expenditures of the deposit insuring organization, provides it with sufficient funds to enable it to pay a certain percentage share of deposit amounts to depositors in the case of bank default, and provides it with sufficient funds as precautionary reserves. To identify and classify healthier and more stable banks, we use credit rating methods that employ two major dimensional reduction techniques. For forecasting nonperforming loans, we develop a model that can capture both macro shocks and idiosyncratic shocks to financial institutions in a vector error correction model. Our results show that deposit insurance premium rates need to vary in relation to banks’ creditworthiness.

WORKING PAPER NO: 757