INTRODUCTION Deposit insurance has historically been reassuringly stabilizing force in a financial system notoriously susceptible to instability. In fact panic were a regular feature of American economic life even as banking was taking roots most spectacularly during the Great Depression. It was the introduction of deposit insurance in 1933 that considerably reduced the vulnerability of American banks to runs. Over the years deposit insurance has taken origin all around the world. DICGC a wholly owned additional of RBI is the second oldest deposit insurance system in the world. It was recognized in January 1962 initially only as a deposit insurance institution. However in 1978 the company was also entrust with the responsibility of credit guarantee and was rechristened as the Deposit Insurance and Credit Guarantee Corporation (DICGC). The objective of extend promise cover to credit was to encourage commercial banks to extend credit to small borrowers belonging to weaker sections of society. But over time it was felt that the credit promise scheme operate by the Corporation had outlived their utility and the schemes were discontinued. The company has now reverted to being an exclusive deposit insurance system. Over nearly 50 years the DICGC has evolve & stimulated up the value chain learning by doing as it were and met many challenges along the way. By far the biggest confront came in 2001 when a large co-operative bank in the state of Gujarat was in trouble. Since several banks mainly many small co-operative banks, had exposure to this bank, its failure had the potential to precipitate a crisis in the banking industry. The Government & the Reserve Bank put in place decision of this bank through a restructuring programme. The key part of this programme was practical action by the DICGC towards prompt payment of claims to the depositors of the bank. This action by DICGC ensured that panic did not spread.

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GLOBAL CRISIS AND DEPOSIT INSURANCE Though the crisis impacted the entire world it artificial different countries in different ways. After the give way of Lehman Brothers in mid-September 2008 there was an sudden breakdown of trust, which spread rapidly from the United States to other advanced economies; causing financial markets in all advanced economies go into seizure. Suddenly there was a great contract of uncertainty about the extent of losses, the ability of banks to withstand those losses, the extent of risk in the system, where it lay and how it might explode. This uncertainty triggers unprecedented panic & almost totally paralysed the entire chain of financial intermediation. Banks hoarded liquidity. Credit, bond and equity markets nearly froze. Several respected financial institutions came to the brink of collapse. Massive de-leveraging drove down asset prices setting off a vicious cycle. In such a situation governments & regulators had to take extraordinary way in a big way. Not surprisingly deposit insurance emerges as the most visible part of the financial safety-net in arresting a panic reaction. Several deposit insurance system increased their insurance coverage limits; in some cases the governments extended blanket deposit guarantee. This way went a long way in restore public confidence in the banking system in economies where it came under serious threat. That India was hit by the crisis dismayed many people. In the years before the emergency the decoupling theory gained academic ascendancy. This premise supposed that even if advanced economies went into a downturn emerging market economies would not be affected because of their improved policy framework, robust foreign exchange reserves, and sound banking systems. The crisis ruptures the reliability of the decoupling theory by engulfing almost every part of the world. India was no exception. The crisis spread to India through finance and real channels. Importantly the crisis also increase through the confidence channel. However in sharp contrast to global financial market which got paralysed on account of a crisis of confidence, Indian financial markets continued to function in an orderly manner, even as the risk aversion of the financial system increased and banks became cautious about lending. The point to note is that the worldwide financial disaster did not pose2

any major threat to the banking system in India at any point of time. As such the need for any special way pertaining to deposit insurance did not arise. However, in line with the global trend, there was also some demand here to increase the deposit insurance cover. If one look even at minor road data it becomes quite clear that this demand had no persuasive force. Under the alive insurance wrap number-wise almost 90 per cent of the deposit accounts are fully covered. Amount-wise over 60 per cent of total insurable deposit are enclosed. We resolute therefore that the costbenefit calculus was not in favour of enhancing the deposit cover. In India the infection of the disaster was effectively contained by coordinated fiscal and monetary measures taken by the Government of India and the Reserve Bank respectively. The results are plain from the marked development in the performance of the industrial sector in recent months upturn in domestic and external financing conditions, revival of capital inflows, increased activity in the primary and secondary capital markets, softening of interest rates and substantial easing of liquidity conditions. GDP growth of 7.9 per cent during the second district of this fiscal (2009 10) was hearty up from 6.1 per cent in the previous quarter. There are however several challenge on the way forward including the timing and sequencing of exit from the expansionary fiscal and monetary policies. These issues are being debate all over the world and occupy the central place in our policy matrix too. The face for the Reserve Bank is to support the upturn process without compromising on price stability. The financial disaster that begins in Asia in mid-1997 resulted in sheer declines in currency values, stock markets, and asset prices in a number of countries. In addition to causing severe effects in Asia, the crisis put pressure on emerging markets outside the region and affected many developed countries. The crisis raised questions about the effectiveness of existing regulatory, supervisory, and financial safety-net arrangements to maintain stability of financial systems. During the disaster & thereafter many governments provided blanket guarantees to depositors and other creditors to prevent the financial and payments systems from collapsing. To this day, some countries continue to explore ways to limit their exposure to such arrangements and their associated costs, and to move toward3

sounder financial systems. course taken include the organization of deposit insurance systems. It has been noted that more than 70 country have implement some form of deposit insurance, and many more are considering doing so. An effective deposit insurance system can promote public confidence and contribute to the stability of the financial system, but only if the conditions necessary for the system to be credible and sustainable are in place.

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MORAL HAZARDS

In a competitive market system, banks fail whether the system is in financial crisis or not. The main objectives of a deposit insurance system are to add to the stability of the financial system & to protect small depositors when banks fail. A well-constructed deposit insurance system will achieve these objectives by significantly reducing the risk of bank runs and the disruptive breakdown of essential banking activities that accompanies such runs. It will also contribute to the smooth functioning of the payments system and the credit mechanisms, and it will facilitate the exit of problem banks. The exact position of a deposit insurance system in a country depends however on the public-policy objectives it has been mandated to achieve. When allowing for the organization of a deposit insurance system policy-makers must weigh moral-hazard issues. Moral hazard refers to the incentive for banks to engage in riskier behaviour than they would in the absence of insurance. Moral hazard may be particularly acute for institutions that are on the verge of insolvency. Furthermore, because they are insured, depositors are not motivated to exercise discipline in selecting and monitoring the financial health of their bank. Policy-makers have at their removal a number of measures to limit moral hazard without negating the benefits of deposit insurance. These measures include imposing relatively low insurance-coverage limits; charging premiums based on the risk profiles of member banks; applying some form of coinsurance; altering the rankings of depositor claims through depositor preference; imposing losses on uninsured depositors, other creditors and shareholders when a bank fails; introducing personal liability incentives on directors and officers of banks to promote good corporate governance; requiring insured banks to follow recognized accounting practices and to hold sufficient capital and uninsured liabilities; promoting transparency & more disclosure of financial information; and establishing a strong regulatory and supervisory system with an effective closure regime that minimises costs to the deposit insurer. When combined with way to control moral hazard deposit insurance can contribute5

to financial stability while maintaining sufficient discipline. Accordingly, policymakers must consider the appropriate trade-offs between moral hazard and market discipline in the context of their objectives, given their countrys history, culture, legal regime, political environment, institutional arrangements, and current financial and economic situation. Strategic Analysis Model A tool for policy-makers As a tool for assisting policy-makers in determining how to design, implement, and enhance an effective deposit insurance system, a brief overview of strategic analysis follows: 1. Setting out the public-policy objectives The analysis should begin by list the related public-policy objectives to be attained preferably in a public-policy paper. This study should take into account the amount to which the conditions are present in a given country. The policy paper should set out the key attributes and important elements of the system in determining the mandate and the powers to be given to the deposit insurer. As well, the policy paper should outline the role of the deposit insurer within the financial safety net and the deposit insurers relationship with the other participants in the regulatory and supervisory regime. There is a variety of coinsurance systems in use today. Where coinsurance is applied on deposit balances above a certain threshold, the deposit balances below that amount can be protected in full while at the time limiting the degree of moral hazard.

Strategic Analysis Model A Tool for Policy-makers

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Designing, Implementing and Enhancing an Effective Deposit Insurance System

2. Situational analysis against conditions Step 2 should consider the structure (including ownership extent of competition & size of institutions) & strength of the financial system. The analysis should address the state of the legal regime; the economic environment; the regulatory and supervisory system; the quality of accounting, regulatory and auditing standards; and the disclosure regime. This analysis should expose the strengths weaknesses, opportunities & threats present in the environment and identify the changes required to construct an effective deposit insurance system. 3. Validation Once the situation examination has been completed there should be a review & validation process (Step 3) against the proposed public-policy objectives as well as the key attributes and important elements of the system. Adjustments should be made if necessary.

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4. Strategic action plan After the justification phase has been completed a planned action plan (Step 4) should be developed. This plan should set out the goals (deliverables) & their priorities, time frames, critical paths, communication strategies & consultation processes. It should also define how the deposit insurance system will be made operational and how it will deal with transitional issues. In transitioning from a blanket promise care must be taken to ensure that the banking system is not disrupted. In this regard, policy-makers should have in place contingency plans to deal with any adverse consequences. It is critical that the public understands the planned changes and the time frame within which they will be completed. 1 5. Implementation phase and acceptance Functioning of the deposit insurance system & other necessary changes (Step 5) should be supported by a mechanism to track progress and identify any adjustments required. The purpose of this point is to render the system operational & deal with transitional issues. For example appropriate corporate governance of the deposit insurer (the board of directors, senior management, internal controls, and an accountability regime) will need to be put in place. Also, budgets, funding, and access to information, including information-exchange arrangements, need to be addressed promptly. 6. Ongoing evaluation and validation Because of the active nature of financial systems there is a clear need for ongoing evaluation and validation of the effectiveness of the deposit insurance system, which may require changes after it becomes operational. This continuous-improvement process should incorporate new developments in the financial system and the lessons learned at home and abroad and should allow for timely changes to the system. This continuous-improvement process should include benchmarking against core principles, guidelines and best practices.8

Conditions for establishing an effective limited-coverage deposit insurance system Certain conditions have to exist for an effective and credible limited-coverage deposit insurance system to be established. These include: a sound legal regime; a stable macroeconomic surroundings & policies steady with maintaining a safe & sound banking system; a financial system branded by suitable regulation & effective supervision; compliance with recognized accounting auditing, & regulatory standards; and an effective disclosure regime.

In an ideal globe all of this situation would be present before deposit insurance is introduced; however in many cases this may not be practicable. Thus, careful attention needs to be placed on when and how a deposit insurance system can be introduced successfully. Key attributes of an effective deposit insurance system Key attributes of an effective deposit insurance system identified are: the framework upon which a deposit insurance system is recognized should openly define its benefits including insurance coverage & limits; there should be obligatory bank participation in the deposit insurance system; there should be clear mandate & defined roles & everyday jobs for the deposit insurer, the regulatory and supervisory agencies, and the central bank (the agencies). Arrangements should include an accountability regime and close coordination and the free flow of timely information among the agencies; the deposit insurer should have well-defined funding mechanism in place to quickly meet its obligations to depositors; & the public should be knowledgeable of the key basics of the deposit insurance system to instil confidence9

DEPOSIT INSURANCE SYSTEM It is clear, therefore, that deposit insurers can perform a range of functions depending on their mandates. Paybox systems, for example, largely confine themselves to paying claims of depositors after a bank is closed. Deposit insurers in risk-minimization systems, by contrast, have broader mandates, such as the power to control entry into and exit from the deposit insurance system, to assess and monitor risk, and to conduct examinations of banks or request that their affairs be examined. Risk-minimization systems may also have the power to provide financial assistance to problem banks and may have intervention powers. As well some riskminimization systems may be charged with resolve bank failure including finding least-cost solutions. Once the public-policy objectives are recognized the deposit insurance system must be properly planned. In its design policy-makers should take into account the income available in a particular country. Thought must be given to such matters as coverage & limits; whether the system should be private or government-backed; the funding mechanisms, including whether to institute insurance premiums; depositor preference; the ability to assess risks and control exposure to loss; informationexchange 1 (i) Coverage and limits The scope of deposit insurance coverage & its limits depend on a country willingness & skill to balance the goal of achieving financial stability with the introduction of incentives for depositors to exercise some discipline. Deciding what to cover and where to set the limits involves a trade-off between depositor discipline and financial stability. Limits that are set too low are improbable to prevent bank runs in the event of financial troubles. However limits that are set too high limit the discipline that depositors can exert on banks to control their risk-taking. A few countries have implement various forms of coinsurance as a means of instilling more marketplace discipline. Although it was renowned that not all coinsurance systems are able to maintain depositor confidence when the financial system is10

arrangements;

public

awareness;

and

necessary

operational

considerations.

under serious stress, where the coinsurance system is structured to protect depositors up to a certain minimal amount this can be achieved. (ii) Private or government deposit insurance systems

There are many variations of private & public systems in place. Some form of a banking industry group usually runs private guard systems. These systems are usually not established by legislation, have no legal obligation to pay depositors, have no government involvement in their operations, and have no government backup support. As a effect these system do not depiction by themselves the government & taxpayers to loss. Private defence systems can function efficiently in normal times if failures are infrequent & minor. In a generalized economic downturn, when the protection system is under stress (for instance, in dealing with a wave of failures or a large failure) the capacity of such a system to absorb losses and its ability to pay depositors may become problematic. These personal systems are less possible to maintain depositor self-assurance in such times. In these conditions the government may have to provide a backstop to the protection system, thus exposing the safety net without certain safeguards that would otherwise be in place with a governmentbacked system. By contrast there are personal deposit insurance systems that have a law-making underpinning. These systems are required to pay depositor claim & usually have access to government assistance, often in the form of interest-bearing loans. Thus clear private deposit insurance systems with these elements can maintain depositor confidence. Certain government-backed civic systems provide the full faith & credit of the government & are part of the financial safety net. As a result, they are able to maintain depositor confidence even in times of stress. The credibility of such systems, however, is linked to the governments ability to stand behind the assurance that it provides to depositors. 2 (iii) Funding mechanisms11

There is a selection of backing options available to deposit insurers which range from an ex-ante to an ex-post basis or some combination thereof. In an ex-ante system, the deposit insurer is often able to build a fund so that financial resources are readily available when a failure occurs. A major consideration of an ex-ante system is formative the size of the target fund & its investment policies. An important principle of an ex-ante system is that banks contribute to the deposit insurance system by paying premiums before their demise. There is a trend toward the adoption of exante systems. Deposit insurance systems that are fund on an ex-post basis by contrast rely on the ability of surviving banks to fund losses after they have been incurred. In many cases, the need to pay assessments or levies to deal with failures occurs at an inopportune time, and the funding requirements may impose a financial burden on the industry. At times both ex-ante & ex-post device may need to rely on additional financial resources such as loans or government support. In some countries, deposit insurers also have access to financial markets for their funding needs. It is essential that policy-makers consider how the deposit insurance system can deal with failures in normal times and those that may occur in waves during times of stress. Regardless of the funding mechanism, no deposit insurance system can withstand, on its own, a systemic crisis. When deposit insurance systems are fund through premium policy-makers have a choice between a flat-rate premium or some form of differentiated premium based on a banks risk profile. Many country are adopt risk-based premium or some form of a differentiated premium system to help address moral hazard, but there has been limited experience so far. Although a right planned risk-based premium system can reduce moral hazard adopt flat-rate premiums in newly emerging or transitional economies may be more appropriate given the potential difficulties involved in the design and implementation of risk-based premiums. These difficulties include finding appropriate and acceptable methods of differentiating institutional risk; obtaining reliable and appropriate data;12

considering the transparency of the approach; and examining the potential destabilising effects of imposing high premiums on already troubled banks. 3 (iv) Depositor preference There could be a broad difference in the place of depositors among creditors in the event of a bank failure. In some countries, insured depositors have priority over all other claimants while in others depositors rank equally with unsecured creditors. Depositor favourite actions can affect market discipline good hazard & the cost to the deposit insurance system. There are trade-offs to be considered in deciding on depositor and creditor ranking. For example, when insured depositors rank in priority to other creditors, it has been observed that the latter will act more definitively in imposing market discipline. Furthermore, lower-ranking creditors will try to protect themselves through various means, such as netting arrangements, collateral demands, and additional charges. It has also been argue that depositor favourite may reduce the incentive for the agencies to act promptly in dealing with a problem bank. On the other hand, depositor preference is beneficial in reducing the cost to the deposit insurer because depositors have priority over other creditors in a bank failure. Therefore depositor favourite is an important consideration when establish a deposit insurance system because it can significantly affect who absorbs the cost of a failure. 4 (v) Information-exchange arrangements Because few deposit insurers have managerial authority it is critical that they have access to supervisory & banking information. The effectiveness of a deposit insurance system is enhanced if there is a strong information disclosure regime, characterized by transparency, and if the insurer has timely access to requisite banking and supervisory information. Deposit insurers require different type of information depending on their mandates. In a pay box system for example information is essential to make sure that the deposit insurer can free its payout function on a timely basis. If not, confidence could erode and render the system ineffective. In a risk-minimising system, the need for information is even greater. (vi) Public awareness13

It is necessary that the public be knowledgeable about which products are enclosed by deposit insurance. This is especially true as financial market are varying rapidly & new products are introduced. Many countries have widely publicized the terms and conditions of deposit insurance coverage. Public alertness is particularly important for newly recognized deposit insurance systems. Although the costs of ensuring that the public is informed may be considerable, the need for public awareness should not be underestimated. 5 (vii) Operational considerations Operational issue must be careful when designing a deposit insurance system. These include a sound corporate governance framework, including internal controls; the availability of skilled human resources, and up-to-date technology; and adequate operational funding. Furthermore, human-resources issues such as compensation, indemnities and incentives should be addressed in order to attract and maintain knowledgeable staff. The matter of personal liability contact was raised & there was agreement that any disincentives to perform should be eliminated.

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DEPOSIT INSURANCE ISSUES As noted earlier a number of countries implemented open government cover guarantee to prevent the collapse of their financial systems & restore or achieve financial stability. As financial constancy returns many of these countries are focusing on ways to make a smooth transition from blanket guarantees to limitedcoverage deposit insurance systems. The primary basis for governments to adopt an open blanket assurance is to reinstate confidence in the financial sector during a major crisis. Experience shows that depositor and creditor confidence can erode quickly, and this may have a severe effect even on relatively healthy institutions. To maintain confidence, depositors & creditors require immediate & extensive government assurance of the safety and availability of their deposits and claims. Another reason for adopt open blanket guarantees is the belief that they will provide the government the time & opportunity to restructure problem banks, thereby avoiding the need to deal with closure decisions. The main benefit of instituting blanket guarantee is to avoid extensive bank runs & thus maintain constancy in the financial system, thereby delaying and reducing the governments financial exposure. Nevertheless, the use of blanket guarantees can ultimately prove costly, particularly when banks and others view the blanket guarantee as a licence for excessive risk-taking. This is especially the case when the owners, managers, and large creditors of problem banks do not incur losses during the restructuring of the financial system or during failures. The use of cover guarantee can obscure problems in government economic policy & in the legal, regulatory and supervisory regimes. For instance blanket guarantees can provide a false sense of security. Thus it is important to provide banks & the regulatory & supervisory agencies with incentives to address & correct their problems & weak practices in the context of a comprehensive reform program when introducing or reverting to a limited-coverage deposit insurance system. There are various prescriptions for moving to limited-coverage deposit insurance15

systems but the timing will depend on the countries progress toward meeting the conditions for establishing an effective deposit insurance system. Public confidence and stability of the financial system are critical considerations. In all situations there should be a well-structured device to reduce the blanket guarantee over time. After a country has suffer a financial disaster it is best to ensure that most of the major problems relating to the financial crisis have been adequately addressed before transitioning to limited-coverage deposit insurance. However if government wait for all deficiency in an economy or financial system to be addressed or the system to be reformed, blanket guarantees could become entrenched. If necessary the original time border for transitioning to a limited-coverage deposit insurance system should be modified to reflect the state of the necessary reforms, the possible effect on public confidence, and the ability to achieve the public-policy objectives. Moving too fast to limited-coverage could guide to instability & capital flight which could prolong the crisis. When moving from a cover promise to a limited-coverage deposit insurance system there are a number of other issues to be considered. These include deciding whether to grandfather deposits covered under the blanket guarantee for a period of time and how to phase-out the guarantee for other liabilities. In addition, it may be appropriate to phase in coverage of new deposits by reducing the insurance limit over time. There is a social cost to providing a cover assurance as the guarantee is ultimately bear by taxpayers. In a limited-coverage system however there is a exact cost paid by the bank through premium or levies. Imposing premiums or levies must not undermine the competitiveness of the banks or destabilise them, especially during the transitional period. In addition there should be suitable mechanism in place during the transition period to provide the deposit insurer with the required funding. To maintain public confidence, the new limited-coverage deposit insurance system must be well understood.

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RECENT EXPERIENCES WITH DEPOSIT INSURANCE Deposit insurance systems are not future to cope with systemic monetary crisis by themselves. The motion of total crisis requires broad, co-ordinated government action. Financial-sector liberalisation needs to be accompanying by suitable changes to the regulatory supervisory and deposit insurance systems. If not, stress in the financial system may cause governments to introduce blanket guarantees, thus exacerbating the problem of moral hazard. Appropriate incentives need to be in placing in supervisory & where appropriate in deposit insurance systems to ensure early detection of problems in the banking system and to ensure prompt remedial action. The example is where early detection and intervention reduced costs to the deposit insurance system and maintained stability of the financial system. Weaknesses in bank management a lack of capable people to deal with complex issues & patience contributed to delays in dealing with bank problems & at times, increased costs to governments and deposit insurers. Deficiency in the flow of information from the banking sector & poor information swap among the agencies undermined the ability of some deposit insurance systems to carry out their mandates. Roles & responsibilities among the agency were often not properly defined or were not always compatible with the public-policy objectives. In some cases, clear accountability regimes were also absent, and this hindered the ability to resolve problems and assess the performance of each agency. Furthermore, the performance of each agency should be assessed and reported accordingly. In a number of countries accounting & auditing standards were either not applied consistently or were non-existent transparency & disclosure regimes were lacking, bank risk-management and corporate-governance practices were deficient, and asset-valuation methodologies were inadequate. As a result, early detection and timely intervention became difficult. These factors resulted in higher overall expenses to taxpayers & deposit insurers. In times of strain insufficient alertness of deposit17

insurance systems eroded public confidence. Accordingly, the public should be kept informed of the benefits and limitations of deposit insurance. This could also serve up to ensure that the public is not led to consider that it has more protection than is the case as such a misunderstanding reduces market discipline and increases moral hazard. The incapability of agencies to become accustomed quickly to changing banking conditions delayed their ability to address problems quickly. This inability was based, in part, on poor information systems and the lack of skilled human resources. It is also noted that in a number of country workers of deposit insurers & other agency were held personally liable for actions taken on behalf of their organisations. This was seen as a serious impediment to performance & to satisfying mandates. Legal regimes were inadequate for supervisors & deposit insurers to complete their mandates. This was particularly evident when dealing with bank closures, liquidating assets & resolving creditors claims. Not enough way to limit moral danger & increase market discipline were in place to support deposit insurance systems. For example policy-makers should consider introducing personal liability incentives against directors and officers of banks to promote good corporate governance. Furthermore, effective and early closure regimes accompanied by least-cost approaches to bank failures should also be considered. The extended use of lender-of-last-resort services by a bank was seen in many instances as an early warning of solvency problems and therefore should be monitored closely and communicated to the other agencies.

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DEPOSIT INSURANCE PREMIUM

With deposit assurance depositors accept the risk-free rate of return on their accounts because they lose no principal or interest if their bank becomes insolvent. When the insurance premium equals banks assessment of the value of the shelter created by their limited liability, deposit insurance eliminates the excess risk premium that banks pay depositors, thereby reducing the effective cost of deposits. This lower cost of funds encourages banks to increase their leverage, thereby reducing the equilibrium risk premium for loans. The following assume that from the banks view the insurance premium accurately reflects the risk in their portfolios. Although deposits can be insured by private entities, a government agency likely does so more efficiently. To eliminate depositors excess risk premium, insurers must be able, without restriction, to audit the quality of banks proprietary information, and depositors must be certain that insurers will satisfy their obligations. The sharing of proprietary information with a private insurer poses risks for intermediaries, especially when the insurer might take a position in competing intermediaries. Yet an insurer that covers many mediators might provide insurance more efficiently because of economies of scale in gathering information and to a better diversification of its own risks. A public group might best understand these economies without creating a substantial conflict of interest at least in the absence of a crisis. The insurers are themselves mediators whose cost of funds & whos pricing of premiums depend on the publics view of their business & the value of their guarantee depends on their proprietary information and capitalization. As an insurers leverage rises, not only does its own cost of funds rise, but banks cost of issuing deposits also rises as depositors recognize that the insurers guarantee becomes less certain. When insurers possess full information about the risk in banks proprietary assets, private deposit insurance is functionally equivalent to banks maintaining more capital (that provided by insurers) to protect their depositors claims. In these circumstances, the excess risk premium that banks effectively pay their depositors would fall only as much as the extra capitalization permits. When insurers are no better informed than the public at large, private deposit insurance19

fails to reduce the excess risk premium that banks pay on their deposits any reduction in depositors excess risk premiums is offset by the excess premium banks must pay for their insurance. For example when bank issue subordinated debentures in some set proportion to their deposit; those who hold this debt provide a degree of insurance to depositors. This insurance is limited to the value of the debentures, which in the depositors view effectively provides more capital to protect their claims. If the holders of subordinated debt stare the potential returns of banks assets no differently than depositors this arrangement only reallocates a share of depositors risk to bondholders without altering banks effective cost of funds. On the other hand, if subordinated creditors, unlike the public, could accurately assess the quality of banks proprietary information, they still would require a premium to cover their own (opportunity) cost of funds, especially if they intend to trade these bonds in public markets. This premium likely would be greatest & banks cost of funds would approach that required by uninsured depositors when the public is most wary of the returns on banks assets, which often occurs during financial crises. The following also assume that bank pay a episodic premium for their deposit insurance. Insurers might measure each go-between a periodic premium that reflects the risk in its balance sheet (pay-as-you-go) or might establish reserves which, in turn, could be held by the insurers (deposit insurance fund) or could be implicit and held by the intermediaries themselves (mutual guaranty). In competitive markets, the first two arrangements are equivalent provided intermediaries implicitly receive a risk-adjusted rate of return on their insurance reserve that reflects the return that they earn on their assets. When intermediaries earn rents, their diverting capital to an external reserve that earns no rent is more costly than their paying periodic premiums or maintaining an implicit reserve. When reserves are implicit and guarantors draw capital from the survivors to pay the obligations of the insolvent, then intermediaries risk maintaining inadequate or excessive reserves because they cannot accurately assess the risks taken by others. In this case capital needs & other controls that limit the risks taken by intermediaries can serve the interests of the intermediaries themselves as well as those of their creditors. Deposit cover diminish the risk premium for loans by reducing the cost of deposits20

which fosters banks demand for this asset. When circumstances do not encourage banks to bear substantial risk by holding a very great share of loans, the cost of deposits and the risk premium for loan falls reasonably little with the introduction of deposit insurance. When banks are less averse to risk and expect earning greater rents on their assets the risk premiums on deposits and loans can fall substantially. Although deposit insurance fosters leverage, thereby raising the insurance premium, both this premium and the banks risk of losing their rent remain modest. Banks leverage is limited entirely by the increasing volatility of their return on capital relative to their expected return on capital as their leverage rises and the yield on loans falls. With deposit insurance the premium on loans vary less with the degree of depositors uncertainty about the return on loans than it does without insurance. The premium rises by a decreasing amount as depositors uncertainty increases. Because the share of loans held by bank increase as the bank rent or depositors that intermediaries currently issue a variety of liabilities, including subordinated debt, suggests a disparity of information, a limit to the value of private insurance.

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Implications of the simple model and its generalisation We can see, that without deposit insurance, there are two pure strategy Nash equilibria: (withdraw, withdraw) and (not withdraw, not withdraw). Diamond and Dybvig generalise this model to n players where a certain fraction p of them are type 1 consumers (i.e. they need to withdraw in period one) and (1- p) x n are type 2 consumers (i.e. they gain utility from consuming in period, 1 or 2).

As depositors are assumed to be risk averse, they prefer the liquid asset created by the bank. If the information about the types are public information (i.e. every player and the bank know the value of p), it is possible for the bank to construct an optimal insurance contract for the depositors against being a type 1 customer. This contract is the optimal liquid asset. Hence, under complete and public information, there is no need for deposit insurance because the bank wont fail as all players have exact and correct information about p. That is, we would only have one pure strategy Nash equilibrium: p x n depositors withdraws and (1- p) x n depositors do not withdraw.

This assumption, however, is not very realistic. In reality, no one knows p for sure. And this is exactly the problem and the reason why we have more than one pure strategy Nash equilibrium. A rumour about the bank having liquidity problems (no matter whether it is true or not), can cause the expected p for each depositor to increase. That is, if the depositor assumes that many other depositors will withdraw, it is rational for her to rush to the bank, too. Note, in this case p is completely subjective and depends on the expectations of each player.

This rationality of running to the bank is the result of the sequential service constraint. That is, in the case of a run the bank will pay out the depositors on a first come first serve basis until it runs out of reserves. Hence, each depositor wants to be at the bank before this happens. A pure strategy Nash equilibrium, where it is rational for all depositors to rush to the bank and demand their deposits, is not necessarily bad. What matters, its reason. Generally, one can distinguish between two reasons for a bank run:

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1. A correctly anticipated bank failure (insolvency of the bank) 2. Incorrect rumours about the banks solvency or other problems with the bank due to asymmetric information between depositors and the bank. In the case of bankruptcy as the reason for a bank run, it is actually desirable not to have a deposit insurance scheme in order to discipline banks not to engage in riskier behaviour (Moral Hazard). The market mechanism should sort out inefficient companies, hence insolvency of inefficient banks is generally desirable. Deposit insurance eliminates this mechanism of sorting out inefficient banks. However, insolvency is not the only mechanism that may trigger bank runs. Bank runs can also happen to healthy (and competitive) banks (and did already happen). They can simply be the result of a self-fulfilling prophecy caused by a false rumour for example. A bank run due to such an event is not efficient and undesirable. A false rumour shouldnt lead to the failure of healthy banks. Ideally, we want both equilibria (not withdraw, not withdraw) and (withdraw, withdraw) in our simple model, but eliminate the second reason for the (withdraw, withdraw) equilibrium. This would enable us to enjoy the advantages of asset transformation without the susceptibility to bank runs caused by false rumours.

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How deposit insurance increases stability of the financial system If we now introduce a deposit insurance system to the simple model, we get:

Figure 3: Payoffs with deposit insurance: One pure strategy Nash equilibrium

The (withdraw, withdraw)-equilibrium is eliminated by guaranteeing all depositors withdrawing in period 1 the initially deposited amount of D/2. By doing so, it does not matter anymore whether one is the first or the last one to withdraw. Hence, the sequential service constraint does not apply anymore. There is no incentive for the depositors to rush to the bank, even if others are rushing. In the more general model, each depositor does not have to bother anymore about the fraction p of depositors withdrawing in period 1. To sum up, deposit insurance does succeed in increasing the stability of the financial system. It does so by eliminating the equilibria where it is rational to withdraw. Other Arguments for deposit insurance In analogy to earlier arguments, there are also other arguments in favour of the implementation of a deposit insurance scheme, albeit the first two are more politically motivated than based on economic rationales: 1. In the short run, the reduction of the risk of a bank run through the introduction of a deposit insurance scheme costs almost nothing. The costs will only occur when a bank run actually happens. 2. Deposit Insurance might be used to promote political values such as the protection of small depositors or to increase opportunities of small banks to24

compete with large ones by alleviating concern about potential fragility of small banks. 3. As in many countries there usually exists more or less unofficial implicit deposit insurance, at least for the larger banks. That is, if a bank run occurs the banks (and its depositors) can be quite certain that the government will step in and help them. In such a situation, the introduction of credible explicit deposit insurance system will limit the governments commitment to depositors.

IMPLICIT & EXPLICIT DEPOSIT INSURANCE25

A deposit insurance scheme is usually just one part of a much wider financial safety net, designed to ensure the soundness of banks and to avoid financial crises. Generally, one can distinguish between two basic types of deposit insurance: 1. Implicit deposit insurance is an insurance of deposits by the government that is not necessarily officially communicated. There usually are also no laws or rules requiring the government to provide this insurance. It is an unofficial guarantee by the government to help banks out that are experiencing a crisis (e.g. a failure or a bank run). An example for such an implicit insurance is the Too big to fail problem. Implicit deposit insurance is effectively a government subsidy for the risk of a default as in the case a bank failure (be it due to insolvency or a bank run) the taxpayer will end up paying the bill. 2. Explicit deposit insurance is a similar insurance of deposits by the government. The major difference to implicit deposit insurance, however, is that the measures and actions of the government are well defined in laws and other rules. The government formally commits in advance to guaranteeing some or all of the deposits of failed banks, usually through legislation. Of course, this distinction does not imply that both deposit insurance schemes cannot coexist. In a larger financial crisis it might be socially optimal for the government to help banks beyond its official explicit deposit insurance. The next two subsections about the problems of deposit insurance and its role within a system of bank regulation applies to both types whereas the third subsection is only concerned with explicit deposit insurance.

FINANCIAL STABILITY26

The worldwide financial disaster has also underlined the decisive role of central banks in systemic oversight of the financial sector and in preserving financial stability. This calls for a paradigm shift not sector. Financial constancy needs to be silent & addressed both from the micro and macro perspectives. At the micro level we need to make sure that individual institutions are healthy, safe and sound. But an important lesson of the disaster has been a reiteration of the fallacy of composition that a collection of safe and sound financial institutions does not necessarily deliver a safe and sound financial sector. We need to take care of systemic stability as a part & distinct duty. This calls for protection financial constancy at the macro level through what has now come to be called macro-prudential regulation of the system as a whole. Today RBI is an active member in some important international institutions that seek to promote more effective regulatory structures, and financial and systemic stability. We have for some time now been shareholders of the Bank for International settlement (BIS) & member of the group on Global Financial System the group on Payment and Settlement Systems and the Markets Committee. Post disaster we have also become members of the financial constancy Board and the Basel Committee on Banking Supervision (BCBS).of course we have been an active member in the G-20 deliberations. DICGC challenges for the future One key face is dropping the time taken to settle claims. Though the business has been able to resolve all claims within the statutory time limit, its goal is to go beyond the statutory prescription, and ensure settlement of claims within a few days of liquidation of a bank as against a few months taken now. Towards this end, effort is required in two directions. First DICGC must have a computerised depositors data base in respect of over 85,000 branches spread across the country. Second the entire process of file claim by the liquidator and their processing by the Corporation should be computerized with appropriate connectivity. The business has already initiate steps to move in this direction by formulating an ambitious project of Integrated Claims Management System (ICMS).

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The second challenge pertains to broadening the mandate of DICGC. DICGC is presently working as a pay box system. Going forward we are exploratory the option of transforming it from a pay-box system to a system attending to all aspects of bank resolution. This may, however require extensive reforms including a thorough change in the DICGC Act, 1961. However certain type of the financial sector supervision and regulation as prevailing in India may have to be kept in view. For example it may not be necessary to have separate managerial machinery in DICGC independent of the Reserve Bank as is the practice in some other jurisdictions, notably the United States. Deposit insurance post crisis The global financial disaster has underscored the importance of a well designed clear deposit insurance system in maintaining financial stability. By assure depositors that they will get immediate payment to the extent of the insured amount, a deposit insurance scheme can contain financial contagion. Indeed there is a number of contrarian examples to show that bank panics were exacerbated in situations where deposit guarantees were not explicit, not incentive compatible and did not have the resources to back their guarantee obligations. In order therefore to motivate the trust & confidence of stakeholders, a deposit insurance scheme must satisfy two criteria first, it must be adequately funded, and second, it must have robust delivery systems in place to effect payments within, if not well within, the assured time.

CONCLUSION When capital markets are not entire the border between regulatory policy &28

macroeconomic policy is not very sharp. The level and cyclical behaviour of the cost of capital depend on the regulations that govern intermediaries capacity to manage their risks. Insurance and capital requirements ordinarily diminish the volatility of returns; yet, with broader effective insurance coverage and higher capital requirements for intermediaries, returns also are more likely to jump in response to smaller macroeconomic disturbances. Consequently, the stability of intermediaries and of returns on financial assets ultimately depends on the stability of returns on investments as achieved by monetary and fiscal policies. Macroeconomic policy essentially underwrites the lower cost of capital promised by insurance and the security promised by capital requirements. The dependence is mutual: Clearly if the [Federal Reserve] System is dedicated to a policy of monetary ease in times of depression, then bank-examination policies should follow a similar commitment. Or if the System is dedicated to a policy of credit strictness in order to curb an coming up inflation, then bank-examination policy should be brought in line with that same intention. Neither act was possible however so long as examination were also devised by the FDIC and the Comptroller, whose personnel were disposed to follow the same policies regardless of prevailing economic conditions. At times of incipient crisis even the distinction between macroeconomic policy & regulatory policy can become moot. When markets are not complete, the governments and central banks of large, diversified economies essentially become their ultimate intermediaries. Once the ability of private mediators is strained their attempts to manage their risk prudently can precipitate disintermediation and their insolvency. At these times, either by supporting the value of intermediaries liabilities through contributions of equity or loans or by directly supporting the value of assets, these intermediaries of last resort can mitigate systemic threats and support the solvency of private intermediaries by preventing a substantial transfer of risky assets from their portfolios to the public. These governments considerable capital their potential claim on their countries current and future income allows them to act as the ultimate lenders of last resort and insurers of assets values. Governments and central banks in smaller, less diversified economies, especially those with relatively volatile returns on their capital assets, have less capacity to support the return on investment or their intermediaries. As a result the insurance & capital needs that29

might normally allow their intermediaries to attract funds on favourable terms also can precipitate financial crises more readily when assessments of the returns on their investments deteriorate.

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1313-34. Allen L. and A. Saunders. 1993. patience & assessment of Deposit Insurance as a Callable Put. Journal of Banking and Finance, vol. 17, pp. 629-43. Berger, Allen N., R. J. Harrington, and G. P. Szego. 1995. The Role of Capital in Financial Institutions. Journal of Banking and Finance, vol. 19, pp. 393-430. Buser, S. A., A. H. Chen, and E. J. Kane. 1981. Federal Deposit Insurance Regulatory Policy & Optimal Bank Capital. Journal of Finance, vol. 36, pp. 51-60. Chan, Y. S., S. I. Greenbaum, and A. V. Thakor. 1992. be quite Priced Deposit Insurance Possible? Journal of Finance, vol., 47, pp. 227-45. Navin, Thomas R. and Marian V. Sears. 1955. The Rise of a Market for Industrial Securities, 18871902. Business History Review, vol. 30, pp. 105-38. Ramakrishnan, R. T. S. and A. V. Thakor. 1984. Informational Reliability and a Theory of Financial Intermediation. Review of Economic Studies, vol. 51, pp. 415-32. Sharpe, W. F. 1978. Bank Capital sufficiency, Deposit Insurance & Security Values. Journal of Financial & Quantitative Analysis November, pp. 701-18.

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