Meeting the rationale of deposit protection system

Author:Nikoletta Kleftouri
Position:Institute of Advanced Legal Studies, University of London, London, UK and Faculty of Law, University of Zurich, Zurich, Switzerland
Pages:300-317
SUMMARY

Purpose - The purpose of this paper is to explore the full potential of an effective deposit insurance system. The current financial crisis in Europe has arguably casted fresh doubt on the role and need for deposit insurance. In this regard, the deposit insurance system’s rationale is a key starting issue in order to fully understand its design and role within a financial... (see full summary)

 
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Meeting the rationale of deposit
protection system
Nikoletta Kleftouri
Institute of Advanced Legal Studies, University of London, London, UK
and Faculty of Law, University of Zurich, Zurich, Switzerland
Abstract
Purpose – The purpose of this paper is to explore the full potential of an effective deposit insurance
system. The current nancial crisis in Europe has arguably casted fresh doubt on the role and need for
deposit insurance. In this regard, the deposit insurance system’s rationale is a key starting issue in order
to fully understand its design and role within a nancial safety net system.
Design/methodology/approach – Using the UK regulatory regime as the main reference point, the
deposit insurance system’s objectives are divided into two broad categories: depositor protection and
nancial stability.
Findings – It is argued that a deposit insurance system could only be effective if designed to perform
key regulatory objectives. Otherwise, authorities will keep resorting to other rescue measures, as this
system will never be well equipped to respond to a bank failure.
Practical implications – Notwithstanding recent regulatory reforms, there is still a lack of clear
objectives and, thus, a clear prole for the Financial Services Compensation Scheme, as the UK deposit
compensation scheme. In light of systemic risk and increased demands on prudential banking
regulation, the UK deposit insurance system should be reformed to perform signicant regulatory
objectives.
Social implications The further reform of the UK deposit insurance will enhance depositor
protection and nancial stability, especially amid the euro-crisis.
Originality/value – An effective reform of deposit insurance requires a clear role-setting for deposit
insurance. To this end, this paper offers a comprehensive analysis of all regulatory objectives that the
post-crisis UK deposit insurance system should serve.
Keywords Bank resolution, Financial stability, Deposit insurance, Depositor protection,
Financial services compensation scheme, Government guarantee, Deposit guarantee scheme,
Bank competition, Deposit guarantee schemes directive
Paper type Research paper
The main rationales of prudential bank regulation have traditionally been the safety and
soundness of the nancial sector, and protection of depositors (Dewatripont and Tirole,
1994). Depositors’ protection is often described as the most basic reason for banking
regulation (Spong, 2000). To this end, the deposit insurance system has become an
essential component of prudential bank regulation, sharing the same objectives with the
latter.
In the UK system, the direct rationale of deposit insurance has always been consumer
protection (MacDonald, 1996). Its creation was a result of the growing inuence of the
consumer protection lobby (Hall, 1987), and its remit has since been narrow, conning
This study is funded by the Greek State Scholarship Foundation. I would like to deeply thank
Professor Kern Alexander for his valuable help. All errors and omissions remain the author’s.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1358-1988.htm
JFRC
22,4
300
Journal of Financial Regulation and
Compliance
Vol. 22 No. 4, 2014
pp. 300-317
© Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-03-2013-0009
its activities to the management of the deposit insurance fund and payment of eligible
compensation claims (FSA Handbook, 2013). Nevertheless, such a scheme can also serve
as a valuable regulatory tool, by helping to mitigate nancial system’s instability. Its
introduction in other countries has, thus, been viewed as part of the drive for nancial
stability both nationally and internationally (Allen and Wood, 2006). Diamond and
Dybvig (1983), studying contracts which can prevent bank runs, showed that there are
circumstances when government provision of deposit insurance can produce superior
contracts. In this respect, in the United States, the protection of individual depositors is
perceived to be a by-product of deposit insurance, as it primarily exists to prevent a
dangerous level of instability in the banking system (Cranston, 1997). Similarly, the
main purposes of the European Directive on Deposit Guarantee Schemes are “to
complete the single banking market, strengthen the stability of the banking system and
establish equal competition, whereas consumer protection is only an incidental effect,
inherent in that purpose”[1].
Blair et al. (2007) explain that, unlike general laws of insolvency, the deposit
insurance system guarantees that depositors will be quickly reimbursed, and “no
amount of prudential supervision can provide protection against bank runs equivalent
to the protection deposit insurance provides”. These two attributes, the authors
continue, present the distinct benets that such a system adds to the safety-net
structure. This system may also alleviate political pressures for a fuller government
bail-out and a more hasty resolution of bank failure (Kryzanowski, 2007), creating a level
playing eld between different sized banks. In the beginning of the 2007 global nancial
turmoil, the then reformed UK – following the creation of the Financial Services
Compensation Scheme (FSCS) in 2000 – and EU – following the 1994 Directive on
Deposit Guarantee Schemes – deposit insurance systems were tested and failed to meet
their rationale. As a result, their main design features, such as coverage limits and
nancing arrangements, were reviewed and signicantly extended. Moreover, since
2012, European ofcials have begun discussions on the creation of a European deposit
insurance system, as part of a European banking union. In March 2013, the European
deposit insurance principles were again tested, as part of the Cypriot bail-out, and
rendered ineffective, as the Eurogroup proposed the imposition of losses to all bank
depositors. Therefore, recent European developments call for a fresh examination of
deposit insurance, as the current euro-zone crisis casted doubt on the need for deposit
insurance.
The system’s rationale is a key starting issue in order to fully understand its design
and role within a nancial safety net system. A weighting towards the protection of
depositors’ objective implies a system with low coverage limits, while a weighting
towards the nancial stability will focus on high coverage limits (Blair et al., 2007).
Similarly, depositors’ protection envisages a pay-box mandate, while nancial stability
requires broader powers for the deposit insurer in addition to its payout mandate. This
paper, using the UK regulatory regime as the main reference point, tries to explore the
full potential of an effective deposit insurance system. The system’s objectives are
divided into two broad categories: depositor protection (Section 1) and nancial stability
(Section 2). Section 3 concludes that a deposit insurance system could only be effective if
designed to perform signicant regulatory objectives. Otherwise, authorities will keep
resorting to other rescue measures, as this system will never be well equipped to respond
to a bank failure. As a note of clarication, the terms “deposit protection system”,
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Meeting the
rationale of
deposit protection
system

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