A second key element of the financial safety net is a deposit insurance system (DIS). Although deposit insurance can cause excessive risk taking, a careful design of deposit insurance—complemented by a larger policy package that includes effective supervision, prompt bank resolution methods, and well-designed LOLR procedures—should provide incentives for economic agents to keep the financial system stable.3
Good practices that contribute to a proper operation of a DIS include the following:
• The DIS should be explicitly and clearly defined in laws and regulations that are known to, and understood by, the public so bank customers can protect their interests.
• If one is to reduce the probability of moral hazard in banks and to provide incentives for large depositors and counterparty banks to monitor the bank conditions, “large” deposits, including interbank liabilities, should not be covered.
• Ex ante funding schemes are preferable to ex post schemes.
• Membership should be compulsory; insurance premiums should be risk-adjusted, if possible, to moderate the subsidy provided by strong institutions to weaker ones.
• If depositors are to have confidence in the system, the DIS must pay out insured deposits promptly, and it must be adequately funded so it can resolve failed institutions firmly and without delay.
• The DIS should act in the interests of both depositors and the taxpayers who back up the fund. Consequently, it should be accountable to the public, but independent of political interference.
• The DIS should be complemented by effective supervision and well-designed LOLR policies.
• Because the roles of the LOLR, the supervisor, and the DIS are different, it is often advisable in large countries (but impractical in countries facing a shortage of financial skills) to house them in three separate agencies. Regardless, those agencies need to share information and coordinate their actions.
• If the DIS is to avoid regulatory capture by the industry it guarantees, then placing currently practicing bankers in charge of decision making is typically not advisable. However, bankers should be given the opportunity to serve on an advisory board, where they can offer useful advice.
• If a country operates insurance schemes for financial instruments other than (narrowly defined) deposits—including capital market instruments and possibly insurance—then those types of investor and policyholder compensation schemes should
conform broadly to the same standards as deposit insurance, as described in this chapter.
• Although the inclusion or exclusion of foreign currency deposits in deposit insurance would depend on the features of dollarization, adequacy of foreign exchange reserves, and capacity to manage foreign exchange risks, a decision to include foreign exchange deposits should be based on a clear and transparent legal and regulatory framework that specifies who bears the exchange risk.4
In a systemic crisis, limited deposit insurance may become ineffective. Other measures such as an extended guarantee (blanket guarantee) could be considered in those circumstances. However, as country experience in systemic crises indicates, a blanket guarantee (a government guarantee for all depositors and certain bank creditors) should be provided only if circumstances are favorable for that guarantee to restore confidence and to stop the crisis from spreading and if there is a credible time-bound exit strategy toward limited guarantee.5 One crucial condition to restore confidence is that the government’s fiscal situation be sustainable.