Chapter 19: Deposit Insurance and other Liability Guarantees. Flashcards
What is a contagious run? What are some of the potentially serious adverse social welfare effects of a contagious run? Do all types of FIs face the same risk of contagious runs?
A contagious run is an unjustified panic condition in which liability holders withdraw funds from a deposit-taking institution without first determining whether the institution is at risk. This action usually occurs at a time that a similar run is occurring at a different institution that is at risk. The contagious run may have an adverse effect on the level of savings that may affect wealth transfers, the supply of credit, and control of the money supply. Deposit-taking institutions and insurance companies face the most serious risk of contagious runs.
How does deposit insurance help mitigate the problem of bank runs? What other elements of the safety net are available to FIs in Canada?
Bank runs are costly to society since they create liquidity problems and can have a contagion effect. Because of the first-come, first-serve nature of deposit liabilities, bank depositors have incentives to run on the bank if they are concerned about the bank’s solvency. As a result of the external cost of bank runs on the safety and soundness of the entire banking system, a safety net to remove the incentives to undertake bank runs was put into place in 1967. The primary pieces of this safety net are deposit insurance and other guaranty programs that provide assurance that funds are safe even in cases when the FI is in financial distress.
Other elements of the safety net are access to the lender of last resort (borrowing from the Bank of Canada) and minimum capital guidelines.
What is moral hazard?
Moral hazard occurs in the financial institution industry when the provision of deposit insurance or other liability guarantees encourages the institution to accept asset risks that are greater than the risks that would have been accepted without such liability insurance.
How does a risk-based insurance program solve the moral hazard problem of excessive risk taking by FIs? Is an actuarially fair premium for deposit insurance always consistent with a competitive banking system?
A risk-based insurance program should deter banks from engaging in excessive risk-taking as long as it is priced in an actuarially fair manner. However, since the failure of banks can have significant social costs, regulators have a special responsibility towards maintaining their solvency, even providing them with some form of subsidies. In a completely free market system, it is possible that deposit-taking institutions located in sparsely populated areas may have to pay extremely high premiums to compensate for a lack of diversification or investment opportunities. Such DTIs may have to close down unless subsidized by the regulators. Thus, a strictly risk-based insurance system may not be compatible with a truly competitive banking system.
What are three suggested ways in which a deposit insurance contract could be structured to reduce moral hazard behaviour?
(1) increasing stockholder discipline,
(2) increasing depositor discipline, and
(3) increasing regulator discipline.
How is the provision of deposit insurance similar to writing a put option on the assets of an FI that buys the insurance? What two factors drive the premium of the option?
As long as the DTI is profitable, the owners of the DTI benefit by maintaining a positive market value of equity. If the DTI’s performance falters sufficiently that net worth becomes negative, the owners can put the assets back to the CDIC who will pay off the insured depositors and sell the assets. The premium on this put option, or deposit insurance, is positively related to the level of risk of the assets and to the amount of leverage maintained by the DTI.
What is capital forbearance? How does a policy of forbearance potentially increase the costs of financial distress to the insurance fund as well as the stockholders?
Capital forbearance refers to regulators’ permitting an FI with depleted capital to continue operations. The primary advantage occurs in the short run through the savings of liquidation costs. In the longer run, the likely cost is that the poorly managed FI will become larger, more risky, but no more solvent. Eventually even larger liquidation costs must be incurred.
Under what conditions may the implementation of minimum capital guidelines, either risk-based or non-risk-based, fail to impose stockholder discipline as desired by regulators?
Regulators must be willing to enforce immediately corrective action provisions against banks that violate the minimum capital guidelines.
What is the TBTF doctrine?
Large DTIs are not generally allowed to fail because of the draining effects on the resources of the insurance funds and the fear of contagious or systemic runs spreading to other large DTIs. Thus, the fear of significant negative effects on the financial system usually meant that both large and small depositors in large DTIs are protected.
How do insurance guarantee funds differ from deposit insurance? What impact do these differences have on the incentive for insurance policyholders to engage in a contagious run on an insurance company?
Insurance guaranty fund programs are supported and administered by the private insurance companies.
Deposit insurance is provided by CDIC which is a Crown corporation.
