Recently, many countries have implemented deposit insurance schemes and many more countries are planning to do so. The design of this part of the financial safety net differs across countries, especially in account coverage. Countries that introduce explicit deposit insurance make many decisions: which classes of deposits to insure and up to what amount, which banks should participate, who should manage and own the deposit insurance fund, and at what levels premiums should be set. When countries elect not to introduce explicit deposit insurance, insurance is implicit. In either case, the benefits banks gain depend on how effective the government is at managing bank risk-shifting.
Explicit deposit insurance schemes appeal increasingly to policymakers. First, an explicit scheme supposedly sets the rules of the game regarding coverage, participants, and funding. Second, an explicit scheme is appealing to politicians because it protects small depositors without immediate impact on the government budget. One should, however, not ignore the potential cost of deposit insurance. Deposit insurance reduces the incentives for (large) depositors to exert market discipline on banks, and encourages banks to take on risk. This form of moral hazard has received a lot of attention in the deposit insurance literature.
In this paper, we investigate how different design features of deposit insurance schemes affect the price of deposit insurance. The goals of the paper are twofold: (i) to present several methodologies that can be used to set benchmarks for the pricing level of deposit insurance in a country; and (ii) to quantify how specific design features affect the price of deposit insurance.
Throughout the paper we refer to the funding of deposit insurance as the actual contributions by banks to cover deposits and to the pricing of deposit insurance as the actuarially fair price of deposit insurance. Actual contributions can be made on an ex-ante basis, in which case contributions are typically accumulated towards a deposit insurance fund or reserve, or on an ex-post basis, in which case banks pay deposit insurance premiums or levies only after bank failures occur. Actual contributions by banks can differ substantially from estimates of the actuarially fair price of deposit insurance for several reasons. First, deposit insurance can be over-or under priced. Second, the estimate of the fair price of deposit insurance may be biased. Third, the government may contribute funds or issue guarantees on certain bank liabilities. And fourth, actual contributions are not always smoothed over time, unlike fair premiums that are typically calculated as annual annuities. For instance, many countries establish target fund levels. Once the fund achieves its target level, contributions may be (close to) zero. Also, countries may decide to set contributions high initially in order to quickly reach a certain minimum fund size.
The academic foundations for measuring the value of deposit insurance lie in Merton (1977), who models deposit insurance as a put option on the value of the bank’s assets. Most of the empirical literature on deposit insurance has either focused on the issue of over or underpricing of deposit insurance or on how different design features affect the effectiveness of deposit insurance. No study thus far has systematically investigated how the different design features affect the value of deposit insurance, and therefore its pricing.
In countries with explicit deposit insurance, deposit insurance is under priced (overpriced) if the deposit insurer actually charges less (more) for its services than the estimated opportunity-cost value of these services. Underpricing of deposit insurance services is a sign that banks extract deposit-insurance subsidies. Marcus and Shaked (1984) use Merton’s (1977) theoretical model of deposit insurance to estimate the actuarially “fair” value of deposit insurance. By comparing these implicit premiums with the official insurance premiums for US banks they test empirically whether deposit insurance is over or under priced.
