Bank Insolvency & Deposit Insurance: A Proposal

1. Bank Insolvency & Deposit Insurance:A Proposal Presented by Hu Difeng

2. Outline • Intractable problem facing central banks and bank regulatory authorities • Too big to fail and moral hazard • Illiquidity ,insolvency and the role of the central bank • Deposit insurance • A proposal of adopting a co-responsibility approach

3. The regulatory authorities are on the horns of a dilemma • If really large banks are always to be protected from failing, it will cause oligopoly and inequitable. • If all banks enjoys similar protection, it will exacerbate moral hazard problems.

4. Facing these problems, what can authorities do ? • Impose additional direct constraints over risk-taking. • But the result is likely to be increasing distortions in bank portfolios, as banks try to avoid and evade the effect of such additional regulations.

5. The development of money market and liability management • Liquidity problems, which are not resolved through ordinary market mechanisms, generally imply the risk of insolvency • Examples: banking crisis of 1973-4 in England.

6. But for Central bank ,what can they do ? • Make a snap judgement whether or not to provide support to an institution whose position is extremely uncertain. • Make loans against the collateral of assets those value may more than match such loans. • Try to involve the commercial banks in the conduct of such rescues. • Involve a joint effort between the government and the bank.

7. Deposit insurance • The existence of deposit insurance would not only serve to prevent runs, but also such insurance would allow the community to accept the effects of banking failures with greater equanimity.

8. The first is that it is difficult to assess accurately the degree of risk undertaken by financial intermediaries, and thus to relate the premiums to be paid for insurance to such risk. The second main problem is the nature of banking risks. Two main reasons why it has proven difficultfor private market to provide deposit insurance

9. The problem of setting premiums • Risk-based • Related directly to the volume of insured deposit

10. The extent of deposit insurance’s coverage • Trade-off • More comprehensive coverage can prevent runs • Only cover certain depositors will be less moral hazard

11. The middle way between moral hazard and contagious failures • A division in banking structure. • Deposit balances, which is sight and small time deposits given 100percent deposit insurance but strict constrained • The other creditors of the bank with large time deposit and CDs, with no insurance but unconstrained

12. A proposal:take the form of co-responsibility of the insured • In the sense that the insured would not receive 100 percent coverage ,but some lesser percentage. • The objective is to prevent the widespread development of runs, and to make bank failures more feasible, both small and large, while at the same time making the risk of loss to the insured depositor high to encourage some market monitoring, and to limit banks’ assumption of risk.

13. Thank you