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Deposit Insurance Financial
存款保险金融
存款保险制度在促进经济金融的稳定中发挥了非常重要的作用。在全球范围内大多数发展中国家有存款担保制度。它是政府干预出面担任安全卫士，防止银行倒闭的一种形式。本系统还有助于在降低银行系统崩溃概率。安全网的安排，让消费者对自己的钱存入银行有信心，从而降低了银行挤兑。另一方面，存款保险制度不是设计用来导致银行危机，它会激励银行承担过度风险。
银行挤兑是金融危机的类型，它发生在在大量存款和他们的钱被收回同时担心该银行可能破产的时候。此操作将导致严重的流动性问题，从而导致银行倒闭。金融行业在不同国家之间有它的相互连结的根，一个机构的失败可能会导致另一个的失败，并可能威胁到金融稳定。
Deposit insurance plays a very important role in contributing to financial stability of the economy. Most developed countries around the globe have deposit guarantee system. It is a form of government intervention to safe guards the depositors during the bank failure. This system also contributes in reducing the systemic banking breakdowns. The safety net arrangement creates confidence to consumers on their money deposited with the banks thereby reducing the bank runs. On the other side when the deposit insurance system is not designed properly can give rise to bank crisis as it gives incentive to the banks to take excessive risks.
Bank run is type of financial crisis, it occurs when large number of depositors withdraw their money at the same time fearing the bank might become insolvent. This action will cause serious liquidity problem which leads to failure of Bank. The financial industries have its roots across different countries a failure of one institution may lead to the failure of another and can threaten the financial stability.
United Kingdom observed a major bank run after a century during the Northern Rock crisis in September 2007. Northern Rock was a Fifth largest mortgage lending bank in UK, relied heavily on the wholesale market for its funds, a world wide liquidity squeeze caused funding problem to the bank. Further, run on bank caused a serious liquidity problem to the solvent bank. From 14th to 17th September 2007 long queues of depositors were found outside the branches of Northern Rock. In theory with depositors being protected such a bank run should not have occurred.
The depositors in United Kingdom are protected by Financial Services Compensation Scheme (FSCS). It is an independent body it has been offering protection to depositors since 2001, it covers all the firms authorised by Financial Service Authority. The run on the bank was a test to the insurance arrangement in United Kingdom. I use the experience of Northern Rock crisis to study on the deposit insurance system in UK.
I show how the bank run occurred with the liquidity insurance model of Diamond and Dybvig (1983). According to this model bank run occurs due to self fulfilling behaviour of the depositors. I relate the run on the Northern Rock bank to this model, I extended the model by showing that information on the bank is initial cause of the bank run. In other words the run on Northern rock bank was not only speculative but it also had a fundamental origin. I analysed the effectiveness of deposit insurance, which according to the model is very effective solution in preventing the bank runs.
FSCS until September 2007 used co-insurance system to protect depositors. Co-insurance system do not provide 100% protection to the depositors, it involves the depositors to take part in the risk of loss. This system is employed to reduce the moral hazards. In other words this system gives incentive for the depositors to monitor on the banks activity. I study the role played by deposit insurance system during Northern Rock crisis. The system failed to protect the majority of depositors and it also did not play its role in preventing the bank run. Professor Willem Buiter commented on the deposit insurance arrangement in the UK during the crisis as a shambles (House of Commons, fifth report of session 2007-2008). My study show the co-insurance system will be very risky at the time of bank crisis. I have argued against the co insurance model with the experience of Northern rock crisis, this system did not work effectively because it was very difficult for the consumers to understand the concept. Furthermore expecting the consumers to judge the funding risks of the banks is unrealistic.
The Northern Rock crisis shows that the consumer understanding and the awareness about the deposit insurance system play an important role in preventing the bank run. As there are many recent designs and new measures to prevent bank runs and reduce moral hazards, we show they must account for a fundamental aspect, as a complex insurance system will be very difficult for the public to understand and will fail to create confidence. I discuss a correct level of compensation limit that UK must have to protect majority of depositors in UK with a statistical data and gross domestic per capita income of the country. I analyse the corrective measures in the insurance arrangement for UK, aimed at improving the financial stability.
It is a tight rope act. On one hand it can reduce the indices of bank run or even stop it all together. On the other hand, when not done carefully it can fuel crises (Patricia A. McCoy). I will give out the rationales for the deposit insurance system and also discuss the moral hazards it creates. Many economists have admitted that the deposit insurance system will give rise to moral hazards if the system is not designed properly. Policy makers choose either explicit or implicit form of protection. Explicit deposit insurance scheme is a formal system, it clearly specifies the amount of compensation to each depositor. UK and most of the other European countries have a explicit guarantee system. In implicit guarantee system the government protects depositors by paying the compensation directly to the depositors. The government decides the compensation limit.
RATIONAL FOR DEPOSIT INSURANCE
The deposit insurance system has direct and indirect rationale. The direct rationale is to protect the depositors against the risk of bank failure. The depositors are the consumers of the financial institutions, so it is necessary to protect them from loss. The indirect rationale is deposit insurance system discourages the bank runs, as the safety net arrangement provides confidence to depositors on their money, there will be only few reasons for the depositor to run on the bank. A bank run can turn a solvent bank in to insolvent bank, it can also run across the borders and cause financial instability. Bank runs at one place can causes the depositors at other banks to panic and go for early withdrawal. Various economic studies show a well designed insurance arrangement can stop the run on the bank and it will reduce the systemic crisis. In absence of this system even false information on a bank will create a bank run. At the time of bank failure government uses the insurance system as tool to stop the spread of failure by providing a full guarantee to the depositors. This system will also help in increasing the savings accounts and encourages the economic development. The deposit insurance system at the time of bank panics will make the entrepreneurs and household to carry on their normal system of work with out any panics as their funds are secure, so this helps in smooth progress in the economy.
A well-designed deposit insurance system can be, at best, just one component of sound financial system. (Gillian G.H.Garacia, 2000)
MORAL HAZARDS OF DEPOSIT INSURNCE
We know the deposit insurance has been very successful in protecting the depositors and contributes to the financial stability. The deposit insurance on the other hand can undermine the market discipline of the economy. Banks with generous deposit insurance system will indulge in riskier activities, they profit by involving risky strategy and transfer the loss of risk to the insurer. This practice will affect the market discipline and financial stability of the country. Secondly deposit insurance system do not give incentive to the consumers and the shareholders to monitor their banks activity, when banks take excessive consumers will not discipline their banks by withdrawing their deposits. When the insurance system is limited banks will be cautious in their activity because the chance depositors monitor the bank is high and will demand more return on their deposits.
The moral hazard of explicit deposit insurance in the recent times has been quite high. When a coverage limit of the deposit is higher the market discipline is significantly reduced (V.P. Ioannidou and Jan de Dreu 2006). Empirical Studies show the explicit deposit insurance has given incentive to moral hazard. The deposit insurance system can equally contribute to financial stability and also destabilize the system. However designing the system effectively will reduce the moral hazards. Many countries do not provide full guarantee to their depositors, the large depositors are left unprotected. This is because they are expected to watch the bank closely and withdraw their money if the bank involved in excessive risk. Insurance scheme, design features and incentive compatible techniques are the key to overcome the moral hazard problems. The coverage limit of the insurance system must be designed effectively to maintain long run financial stability.#p#分页标题#e#
TOO BIG TO FAIL
The government extend deposit guarantee beyond the limit established in the deposit insurance system when the big banks face a failure. This is because a failure of big banks can lead to major financial disruption in the economy. This practice is known as too big to fail. The government intervention to guarantee all the depositors and protect the bank gives rise to moral hazard problem and undermines the long run financial stability. When the large depositors know that the bank is too big to fail they will not police their bank. This policy will also give incentive to banks to take excessive risk, which will result a bank failure.
The term came into common usage in United States during 1984. For example, Continental Illinois the seventh largest bank faced solvency problem during 1984. Federal Deposit Insurance Corporation during the time guaranteed deposits up to $100,000, the insurance guarantees at the time of bank failure was extended and protected all the depositors.(Fedric S. Mishkin, 7th edition) The FDIC injected a huge amount of capital in to the failing big bank and protected the investors and consumers. This policy has made bank failure likely and caused financial instability in United States. The regulators are reluctant to allow the big banks to fail as it can threaten the financial stability. The recent crisis of northern rock also was not allowed to fail because it was classed as too big to fail the government made a decision to protect the bank because a failure to do so may lead to a systemic risk. The government announced full guarantee to its consumers. There are arguments that the northern rock should be allowed to fail in order to maintain market discipline but on the other hand in failing to do so may have lead to a systemic crisis. A serious consideration must be made when the regulators intervene to protect the large banks as it undermines the market discipline. These situations must be handled with care so it doesn't affect the future discipline.
1. CAUSES AND CONSEQUENCES OF NORTHERN ROCK CRISIS
We see the causes and consequences of the crisis. There are various lessons been learned from the crisis. We focus on the deposit insurance system and analyse a corrective measure. The deposit insurance arrangement in UK was criticised by many economists. The FSCS until September 2007 protected 100% of the first 2000 and 90% to the next 33000. The UK government widened its policy after the bank run, protected 100% of the 35000. Northern Rock was formed on 1965 as a building society, it became a limited company on October 1997. Residential mortgage lending was the major business activity, offering deposit contracts and insurance products were the other business activity of the bank. The business grew rapidly, was the 5th largest mortgage lending bank in United Kingdom. The bank was nationalised in 2008 after the crisis.
1. 1 THE CRISIS
The Northern Rock bank had liquidity problems during September 2007 and obtained support from the bank of England as it is the lender of last resort for the UK banks. The bank only had liquidity problems but it remained solvent. The run on the bank caused serious liquidity problems to the bank. The consumers did not feel safe about the money in the bank, Fear that the bank would fail triggered the bank run. The maximum amount of protection was 31,700 during the event on the bank going bust, financial system of UK was at a great risk at the time of crisis.
1.2 BANKS FUNDING STRATEGY
I will now put in front the reason why the bank had the liquidity problem as it was the main reason for the crisis. The northern rocks core business was mortgage lending. The bank used securitisation process to raise its funds, it involved a special purpose vehicle (SPV) called granite which was used as the securitisation vehicle to raise funds. (House of Commons fifth report 2007-2008). Granite is our securitisation vehicle. Securitisation, according to the Northern Rock chief executive Mr Apple Garth The way securitisation works is you borrow against pool of mortgages. The bond holders lend money against the mortgages, they carry the risk and bank do not bear any risk from these loans, so even if it shown in our balance sheet, it has to be a separate legal entity (House of commons fifth report 2007-2008). I use the balance sheet of the bank to know the funding system. A brief summary of the balance sheet is shown in the graph below. By the end of 2006 bank had 77% of its assets in residential mortgages, as mortgage lending is the major activity of the bank. The northern rock bank raised 41% of its funds from securitised debts, major fund have been raised through securitisation. About quarter of the banks total funds came from wholesale credit markets. The retail deposits contributed to 22.6 billion, unlike other banks it did not rely much on the retail deposits. About 10% of the fund was raised by issuing covered and securitised bonds. This was the strategy adopted by the northern rock bank to raise its funds. The northern rock bank had a very unusual funding strategy, this strategy was very risky. As we can see majority of funds came from money markets. When the markets became less liquid during 2007 the wholesale borrowing became difficult to borrow. The bank had to pay higher interest rates on their borrowing because of the world wide credit squeeze, this resulted to reduce the banks profit during the first half of 2007. The bank suffered by the sub prime crisis in United States as it couldn't borrow funds from the money markets, Sub prime crisis in United States was one of the reason for this trouble. The bank tried to diversify its strategy, bank attracted retail deposits from the different countries across Europe, but all theses funding strategies did not work. Because of theses reasons the bank approached Bank of England for a back stop facility, Northern Rock wanted this facility until the credit markets became liberal. Bank of England after serious consideration provided emergency loan facility.
1.3 RUN ON NORTHERN ROCK
.Leak of this information caused a bank run, resulted in long queues outside the most of its branches on 14th September. There were long queues found outside the branches in Kingston upon Thames, Birmingham and Newcastle (www.thisismoney.co.uk). The public feared the bank would fail and rushed to withdraw their money. There were plenty of people outside the branches on 14th September waiting to withdraw their money from the bank, about one billon was withdrawn from the bank on the first day after the news reached the depositors, the bank website crashed in the morning as the depositors tried to withdraw their deposits through internet. The bank couldn't provide fullest service on the internet to their customers. I have withdrawn all my money. I got there at about 8.40am and was about 12th in the queue(www.thisismoney.co.uk). She said it took an hour to take her money out of the bank and when she got outside she found about 50 people waiting to withdraw their money.
Government and the bank made efforts to calm down the public over the weekend. Gordon Brown pleaded to public not to panic about their deposits and the bank assured it will not go bust and their money would be safe. (House of Commons fifth report 2007-2008). But On 17thSeptember Monday people queued in front of the braches to withdraw their money, long queues were found almost in every branch. The share price fell by 40% on that day price of the share was 2.82. Later during the day chancellor Alistair darling made an announcement to guarantee all the deposits in Northern Rock bank. He announced the depositors will not lose a penny (BBC Northern Rock - Time line). So the consumers will be confident about their money in bank and to stop the panic across the country. After the announcement was made the queues gradually disappeared, this was a clear sign of the announcement. Bank of England provided liquidity support to the bank, after the run Northern rock had to rely on bank of England for everyday financing. About two billion was injected every week, by the end of 2007 loans from bank of England was 26.9 billion, twenty six percent of the total liability.
1.4 EVENTS AFTER SEPTEMBER 2007
During October Alistair Darling announced to guarantee 100% of the deposit 35000 and the treasury also guaranteed all the new deposits in the northern rock. The bank had take over offers from virgin media, Olivant an investment company was also the front runner for the bid and about 10 companies showed interest to take over the bank. During February virgin group and the northern rock, own board made the rescue proposal, virgin proposed to inject 1.25 billion and take up the majority of stake and Northern Rock with their share holders backing proposed to raise 500 million (BBC, Northern Rock time line). The treasury was not happy with both the proposal and wanted both the bidders to improve the rescue plan, final they failed to win the bid. The bank was nationalised on 17th February 2008, Ron Sandler became the chairman of the northern rock.
1.5 ROLE OF DEPOSIT INSURANCE DURING THE CRISIS
We have seen rationales of deposit insurance and the role it must be playing in the financial markets. The Northern Rock crisis was a test for the deposit insurance system in United Kingdom. We know compensation scheme until September 2007 provided by FSCS covered 100% of the first 2000 and only 90% for the next 33000. Total amount of guarantee will be 31,700.
The long queue outside the bank show the safety net arrangement was not inefficient to prevent them. The scheme did not provide confidence to the depositors. Many consumers were distressed and were waiting in front of the bank to withdraw their deposits. Consumers feared they will lose entire deposits, primary role here for the insurance scheme is to provide safety and calm the public. Fear among the public kept increasing day after day. The compensation scheme did not play its role.#p#分页标题#e#
Later during the bank run deposit guarantee was used as tool to stop it. The run on the bank was significantly reduced after the government guaranteed all the deposits in Northern Rock bank. All the measures taken by government to stop the run did not work, Only after the announcement of the guarantee the run came to an end. There was a real impact after the hundred percent guarantee deposits guarantee was announced by the government. The share prices which fell sharply on the 14th and on the 17th morning went up after the government guaranteed the deposits to its customers. There was a desired impact after the announcement came.
A well designed compensation scheme should help to stop the bank runs or it can trigger a blown contagion and can cause financial instability. I will be discussing the reasons for the failure role in this paper.
2.) THE LIQUIDITY INSURANCE MODEL WITH THE NORTHERN ROCK
The Diamond and Dybvig (1983) model has made a very important contribution to the theory of banking. In this section I am using this model to explain the bank runs and bringing out the effectiveness of deposit insurance in the financial system. I will be relating the run on Northern Rock with this model show how the run occured. The model explains banks are subject to runs and it will have liquidity problems and it brings out deposit insurance as effective solution to stop bank run. Under this model the banks act as intermediaries between depositors and borrowers, it shows the important function of banks is to create liquidity. The model views bank run as self -filling prophecy.
2.1 The model
The model considers 3 period economy, t= 0, t = 1and t = 2 with one good which can be stored or invested in a productive illiquid technology. There are two type of depositors type 1 depositors are early consumers, will consume when t = 1and type 2 depositors make their consumption late at t = 2. For simplicity the depositor who withdraw early are D1and the patient depositors are D2. The depositors D1 and D2 are uncertain of the time they will be withdrawing their money from the bank during time t = 0. The banks only know the probability of the type of depositors they will be D1 will have a probability of λ1 and late D2 depositors with the probability of λ2.
Depositor D1 will have a utility of u(D1) and late consumers' utility will be ρu(D2).
Both the type of depositors is identical at time 0. The long term technology gives a return R>1 at time 2 and if the investment is consumed early, that is when it is consumed at time 1 a return of L < 1 is obtained.
The expected utility of the depositors at time 0 is
λ1u(D1)+ λ2 ρu(D2).
The model shows role the financial intermediaries in offering liquidity and managing their withdrawals. The banks invest the deposits in long term illiquid technology which would provide with higher returns. The time of withdrawal of the deposits is uncertain, if the depositors make an early withdrawal, then the banks will have to liquidate their assets invested to meet the early withdrawal which will lead to insolvency of the bank. The banks due to this reason would keep part of the liquid assets for the demands of the early withdrawal D1=1 and invest the rest of the proceeds in illiquid assets. By doing this the banks fulfil the obligation of the early and late consumers. The bank offers higher return to the D2 depositors D2 =R which can be met from the amount invested in the illiquid technology.
It is assumed D1* and D2* is the level of consumption during the time 1 and 2.The model shows the market equilibrium will be obtained by increasing the early consumer D1* >1 and reducing the late consumers. So the possibility of bank runs is reduced. The late consumer will receive D1* and if they go for early withdrawal they receive D1* .If the consumers withdraw early it would be worse of because D1* < D2*, so the banks would be able to fulfil the obligation of late and the early consumers thus the financial market equilibrium is optimal. Thus the fractional reserve banking system will be optimal only when the patient consumers do not withdraw early.
2.2 BANK RUNS
There is equilibrium show in this model that is if we assume that the D2 depositor believes that all other depositors will make their withdrawal during time 1, the bank in order to meet the early withdrawals does not have any other option but will have to go for premature liquidation. This will lead to insolvency, as the asset value will be less than its liabilities. When the bank go for premature liquidation its assets value is
λ1 D1* +(1- λ1 D1*)L<1,
.That is the premature liquidation of asset will give a lower value than its liabilities. The liabilities of the bank during the time 1 will be D1* >1. During this situation it will be optimal for all the late consumer to with draw early as the banks will fail before the time 2 because of early liquidation. This is a theoretical game were the depositors takes a decision depending on the behaviour of other depositors. If a depositor believes that the others will withdraw their money early then even he will withdraw his money early and if he thinks other depositors will withdraw their money late then even he will wait until the time 2. This game has tow Nash equilibrium. The depositor will make their withdrawal depending on the decision of others. Run here occurs because psychological reactions of the depositors.
2.3 NORTHERN ROCK CRISIS WITH THE MODEL
I would relate run on the Northern Rock bank with the model. Let us assume that the deposit insurance is absent, we know the business model of the bank it makes majority of its investment in lending mortgages, so the assets of the bank are illiquid. In this case we will not be able to differentiate the late and early consumers.
A large portion of depositors withdrew their deposits after the information leaked, that the bank was in need of emergency support. That is only after Bank of England agreed to provide emergency loan to Northern Rock on 13th September. Large portion of consumers went to withdraw their money on the 14th. The information on the bank was the initial push for the retail run. The depositors, who knew the bank is need of support, would have made their decision to withdraw early. So the initial cause of the bank run is here information based.
It is difficult for all the depositors to have knowledge on the performance on the bank. As the model shows the decision of the late consumer depends on the other depositors. The same can be captured with the run on Northern Rock. The depositors who make late and early withdrawal from the bank here can not be differentiated. The uninformed depositors about the bank performance made their decision on seeing the behaviour of all the other informed depositors. That is on observing the large portion of depositors withdrawing their money from the bank. All the banks have first-come first served rule. So the consumers fear that bank will run out of money and the bank would not be able to meet their withdrawals. Depositors would not want to suffer a loss of receiving their money less than invested, which has made the depositors rush to the bank and withdraw their money early. This scenario explained above is a game in which consumers made their decision depending on the behaviour of other depositors.
There is two type of equilibrium one efficient and inefficient. The inefficient equilibrium is in the case of Northern Rock were there was a coordination failure, that is when all the depositors went at the same time to withdraw their deposits. This scenario of Northern Rock shows the existence of this equilibrium. The run on the bank reduced the liquidity of the bank and the bank had to rely on Bank of England for every day financing. In absence of Bank of England the Northern Rock will have no other choice but to liquidate its asset to meet the depositors. As seen in the model early liquidation will lead to situation were the value of its liabilities will be more than its assets. Value assets during premature liquidation will be
λ1 D1* +(1- λ1 D1*)L<1,
This show the run on the bank will lead to failure as it is impossible for the bank to meet all the withdrawals at one particular time, as they only have fraction of liquid assets and a premature liquidation will cause a bank run.
This scenario shows not only psychological reactions can cause a bank run, but it will have a fundamental origin. The initial reason of the bank run was information based, that is when the late consumers received a signal on the banks performance. With the practical experience on the Northern Rock we can see the existence of this equilibrium. The run on Northern Rock combines fundamental bank runs (information about poor performance of the bank) and followed by the equilibrium depicted in the model of Diamond and Dybvig.
2.4 PREVENTION OF BANK RUN
There are many studies to bring out a solution to prevent the bank runs, the problem of bank runs can be prevented by suspension of convertibility, lender of lost resort facility , narrow banking system and with the use of deposit insurance system.
The remedies for the instability and to prevent bank panics in the liquidity insurance model are to ensure the banks have sufficient liquid assets to meet the claims of all the depositors at time one. The bank can not have hundred percent liquid reserve, all the banks can only have a fraction of liquid asset because the return from illiquid investment is higher than holding liquid assets.#p#分页标题#e#
Under narrow banking system all the assets are kept liquid so it can meet the claims of the depositors at any period of time. It does not engage in maturity transformation of assets, it makes the investments in bonds. The welfare obtained from the narrow banking is dominant by the normal banks and it is also dominated by autarkic situation (absence of trade between the agents) this model show narrow banking as a very restrictive solution. The narrow banking solution can not provide the social welfare level that is been provided by the normal bank. (Wallace 1988, 1996).
Lender of last resort is essential to the financial institutions in providing emergency support and liquidity. The central banks in the country act as a lender of last resort. The emergency facility may not always be guaranteed to the commercial banks. It is a decision made by the supervisory authority at the time of bank panics. This facility prevents the banks from failing and provides liquidity to meet the withdrawal of the depositors. The Bank of England played a very effective role during Northern Rock crisis.
The model show insuring the depositor is an effective solution to prevent the problem of bank run. The deposit insurance scheme is financed by insurance premiums, paid by bank or through taxation. The deposit insurance in this model means, even if large portion of consumer go for early withdrawal, it is not optimal for the other consumers to withdraw early because they are been guaranteed by the insurance scheme. Deposit insurance system is very effective in the financial system to stop the bank runs and maintain financial stability. When the deposits are formally guaranteed then there will not be any reason for the consumers to run on the bank. Depositors insurance system dominants all the other solutions in preventing bank runs. Many studies have concluded deposit insurance as a dominant solution in preventing the bank runs.
Northern Rock crisis clearly shows the deposit insurance system failed to prevent bank run. I will be studying the reason for the failure in the chapter below.
3. REASONS FOR THE FAILURE OF DEPOSIT INSURANCE
3.1 INSUFFICENT COVERAGE
Coverage limit of the compensation scheme is a very important aspect in the deposit insurance system one of the reason for FSCS failing to prevent long queues outside the bank was coverage of compensation scheme. The event during the crisis has showed that the compensation scheme was clearly inadequate. When the depositors are not fully insured they are open to lose some money, so the depositors will avoid this risk. I have used the statistical data from authorities of The Treasury, FSA and Bank of England together published report to analyse this section.
The graph show 96% of the UK deposit account holders had deposits within 35000 and the remaining 4% had balance over 35000. This data show the banks clearly did not cover majority of depositors fully. From this graph we can see only a small number of depositors were protected until September 2007. It was rational for the depositors to run on the bank and withdraw their money. This event has proved that when a depositor is not fully guaranteed then he will run on the bank. Roughly about 92% of depositors were left unprotected.
Another graph below show the distribution of deposit account balances ninety six percent of the depositors contributed to fifty five percent of the total retail deposit balance in the UK and the remaining four percent of the account holders have contributed the rest of the deposits. Many depositors who had balance over 100,000. Most of these people had money in their accounts only for transaction purpose. The large depositors were left fully unprotected. An early withdrawal by them can create liquidity problem to the bank.
. The system did not protect both small and the large depositors and with this data I can clearly say that the coverage limit was inadequate. We also have also noticed the run on the bank reduced only after the government announced to guarantee the 100% of the deposits. This illustrates the coverage limit was insufficient.
3.2 CONSUMER AWARNESS
The Treasury, FSA and Bank of England together published discussion paper on financial stability and deposit protection, has shown the consumers lacked knowledge on the existing deposit insurance scheme with the recent consumer survey. I have used this graph to show the lack of consumer knowledge on the scheme was one of the main reasons for FSCS failing to play its role during the run on Northern Rock.
The consumer survey graph from the paper shows that only 1 percent of the depositors knew the correct limit of compensation. About 85% of the people did not know the correct limits provided to them, 15 % of them had thought they were been provided with unlimited compensation and 4 % felt there was no compensation provide to them during the failure of banks. Even if the safety net was provided to the public, poor awareness on the existing system can result in bank runs.
Another chart below from the paper also show about 80% of the account holders do not remember the compensation limit given to their deposits which was informed to them when they open their account. The chart shows only 2-3% have a clear knowledge on the compensation limit. When the consumers lack knowledge on the scheme, it is very difficult for a system to work effectively. The depositors will run on the bank even if his deposits are protected.
With this survey published in the papers survey clearly indicates the consumer had a poor knowledge and awareness on the system. So the lack of knowledge was a reason for the system playing an ineffective role during the Crisis.
3.3 COMPLEXITY OF THE MODEL
According to study from bank of International Settlements and Financial Stability forum, Deposit insurance system will be more effective only if the consumers understand the benefits and limitations of the existing deposit insurance system. The system can work well only when the consumer understand it well. The system had different layer of cover so the consumers was not convinced about the system. The Northern Rock bank at the time of the bank run has faced huge difficulties in explaining the system to the consumers. The depositors did not understand how co-insurance worked. They also concluded it will take a long period of time to claim their deposits (HM Treasury report). The system it is not easy for the general public to understand during the time of financial crisis and panics. The safety net arrangement is to reduce the fear of public at the time of crisis. When the consumers are not able to understand the model then the deposit insurance will not be able to contribute financial stability. The complexity of the model was another reason for failure of the system.
4. EFFECTIVE MODEL OF DEPOSIT INSURANCE
A very good model of deposit insurance will contribute to financial stability. Designing a good deposit protection system is appropriate. Strong institutional and banking regulation will not be enough to constrain risk. In this section I will be analysing an effective deposit insurance system in United Kingdom that will contribute to financial stability. The compensation scheme has been changed after the crisis, I will also be analysing on the current scheme. I have used the risk reducing methods to bring out a corrective measure of deposit insurance system.
4.1 CO-INSURANCE
Co-insurance is a form of explicit deposit protection arrangement, this technique is very effective and protects against moral hazard problem. Co-insurance encourages the depositors to place their money in very healthy banks. This expectation did not work in the Northern Rock scenario. If this system worked, then the depositors should have been cautious in depositing their money. A statement from Northern Rock show it attracted a good amount of retail deposit from the United Kingdom after the credit squeeze, about 2 billion of liquidity was raised in 6 months time (HM treasury, Fifth report). the bank kept receiving significant money from the retail deposits until the crisis, This show that the depositors couldn't sense the funding problems of the bank. This experience shows it is unrealistic to have expectation on the depositors to judge the risks of the bank. Recent financial instruments the banks are using are very complex for a ordinary depositors to understand. Financial innovations in recent time has made it very difficult for the consumers to realise the banks risks and strategies.
This model has also proved to be very risky during bank crisis, because a part depositors who are not fully protected will certainly run on the banks. Only a full guarantee can stop people from running on the bank. As discussed above the co- insurance is very complex for the depositors to understand.
This crisis has shown that the co-insurance arrangement with a limited cover will be very risky and difficult in reality. However this system was removed after the crisis. This system is very straight forward, depositors are protected up to 35000 and nothing after that, this system will gain consumer understanding.
4.2 COVERAGE LIMIT
The countries which adopt explicit deposit insurance system have a limit on their insurance protection. The level of protection varies across different countries, this differs across nations due to economic condition and financial strengths .Coverage limit is a important element to be considered in designing the system. Overgenerous deposit insurance can lead to financial instability seriously affect the market discipline. For example I am using S&L crisis to explain an over generous deposit insurance can cause financial instability. Savings and Loan are mutual association which offered deposits and offered cheap finance to purchase homes. The financial deregulation occurred during 1980's in United States. The Federal Deposit Insurance Corporation was established in 1934 to increase the financial stability this provision of deposit insurance contributed to financial stability from 1934-1980, it covered deposits up to $40,000. There was number of bank failures from the period between 1985-1992 about 750 financial intermediaries collapsed during this period. Financial innovation, increase in competition and over generous explicit deposit insurance system was the reason for the crisis. The FDIC insured $100,000 of the depositors accounts at that time. S&L's took excessive risk, offering high risk loans and deposits . By doing this S&L were gaining more profits and the risk of loss was transferred to FDIC. The overgenerous deposit insurance system did not encourage the depositors to monitor the banks activity and on the other hand the banks also to advantage of this an engaged in excessive risks. This crisis affected the market discipline and caused instability in USA. Sir Callum Mc McCarthy chairman of FSA commented on US saving and loan problems, it was quite clear that 100% coverage resulted in some distortion of behaviour and some serious moral hazard (HM treasury report).#p#分页标题#e#
One method used to measure the coverage limit is by using the countries gross domestic product per capita. The economic studies show that the bank crisis increases with the ratio of coverage to per capita GDP increase. when the saving and loan crisis happened the coverage was 9 times per capita.
The IMF guide lines, recommend limiting the coverage to one or two times GDP. United Kingdom had coverage less than 2 times the per capita GDP at the time of crisis. The new coverage is close to 2 times per capita. The scheme is in line with IMF guide line any further increase of 50,000 or 100,000 will encourage the moral hazard activity. The European commission deposit guarantee schemes directive requires a minimum guarantee of 20,000 for the EU member state. A Further increase in the scheme would significantly increase the costs to the institutions, an increase in compensation can cause moral hazards. The HM treasury report shows the FSA has a plan of increasing the compensation, which received the information from financial service consumer panel. An increase to 100,000 will significantly affect the market discipline and will give rise to moral hazard problems. An increase in compensation limit to 100,000 will be over 5 times per capita GDP for the UK. An Empirical studies Patricia A. McCoy, 2007, show countries with coverage of over 4 times per capita GDP are likely to experience 3 time crises more than the other countries
Data from British Building Society Association show when the coverage is 35000 then 95% of retail account depositors are being covered, so the current scheme covers majority of depositors accounts. About seventy percent of account balance has been covered by the current scheme, majority of depositor are been protected by the current scheme. A further increase to 75,000 only covers three percent more individuals. But it covers eighty four percent of the total deposits balance in a institution. An effective way to prevent a bank run is by protecting majority of depositors, thus majority of depositors are been protected by the current scheme. Increasing amount to further 75000 or 100,000 will cover mores balances but will affect the market discipline country. With these examples, data from BSA on the retail accounts and with the IMF guide line I conclude a limit more than 35,000 to 40,000 will affect the longer term financial stability and a current scheme itself will be effective in stopping the bank run.
Responses from 49 societies, representing 99% of the sectors' assets.
4.3 RISK ADJUSTED PREMIUM
Risk adjusted premium is another technique that is recently used to maintain market discipline. Institutions pay their premium relative to the risk of failure. This provision is famous among the commercial insurance scheme, greater the risk, greater the insurance premium paid. So when the banks engage in riskier activity will have to pay more premiums. Federal Deposit Insurance Corporation in United States uses this form of funding. This technique will be very effective to alleviate moral hazard if the risks of the bank can be evaluated properly. This will stop the banks from engaging in riskier activities, market discipline can be obtained by using this technique, as the banks will need to pay higher premium than the conservative banks. Risk adjusted premium works better than the normal flat premium. Use of this system has strongly increased over the years.
United Kingdom has a uniform pricing system this will not contribute to reduce the riskier activities of the banks. Introduction of risk adjusted premium will contribute to the market discipline. This method will encourage stopping the risky activities of the bank. The high risk banks will be required to pay a higher premium and will require the conservative banks to pay very less premium. The risk adjusted premium will eliminate excessively risky activities of the banks (FSA, Financial stability report). System must be implemented in United Kingdom to curb the moral hazard. This system can play an active role and contribute to financial stability.
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