With the right incentives, deposit insurance can strengthen stability of financial system

• Pages: 238-240

Page 238

Garcia: “The public must believe the [deposit insurance] system is well funded; it must have confidence that the money will be there when needed. ”

Asurvey of the world’s deposit insurance schemes, which relied heavily on the IMF’s Monetary and Exchange Affairs Department (MAE) staff and country desk economists and resident representatives throughout the organization, provided the basis for Gillian Garcia’s IMF Working Paper, Deposit Insurance and Crisis Management. Garcia, a Technical Assistance Advisor in MAE, spoke with the IMF Survey about how a sound deposit insurance scheme can encourage responsible behavior among banks and their customers and help ensure the stability of the financial system.

IMF SURVEY: What is deposit insurance? And why is it important?

Garcia: A deposit insurance system guarantees that small depositors will receive their funds if their banks fail. In a broader sense, however, a deposit insurance scheme also provides a crucial set of incentives for the financial system. If those incentives are right, wealthy depositors will discipline their banks, bankers will not gamble with others’ money, borrowers will repay their loans, and politicians will resist interfering with sound regulation. If all this happens, you have better banks, faster economic growth, and greater financial stability. Of course, a deposit insurance system can also provide the wrong incentives and actually make things worse.

IMF SURVEY: What, broadly, are the objectives of deposit insurance?

GARCIA: Different countries have different objectives, but the two most popular aims are to help stabilize the financial system and to protect the small, unsophisticated depositor. It’s important to protect small depositors because you don’t want them to get scared, line up outside banks, and be seen on television. That generates a panic among other depositors and politicians, who in turn do some bad and unnecessary things.

Small depositors really don’t have the resources to monitor banks; monitoring is a complex and time-consuming task in a modern economy with derivatives and international transactions. Monitoring should be left to the large depositors—the people with the resources.

IMF SURVEY: What key elements should a country be mindful of in setting up a deposit insurance scheme?

GARCIA: First of all, be realistic. Deposit insurance is no panacea. If you have a weak banking system, improve it before you put your deposit system in place. When you put the scheme in place is also important. Then, you want your system to be compulsory, explicit, and transparent. Once all of that is done, there will be room to fit the design to country circumstances.

The system should be compulsory because if weak banks fail and lose money, deposit insurance premiums will rise, and stronger banks will drop out. Gradually, the system will...