1 Finance Forum 2002 Pricing of Deposit Insurance Luc Laeven Finance Forum 2002

2 Pricing of Deposit Insurance  Explicit deposit insurance should not be adopted in countries with a weak institutional environment (Demirgüç-Kunt and Kane 2002)  But: for countries that decide to adopt deposit insurance, pricing it as fairly and accurately as possible is important  Example: Russia

3 Finance Forum 2002 Outline  Deposit insurance pricing methods  How do specific deposit insurance design features affect the price of deposit insurance?  Is deposit insurance underpriced around the world?

4 Finance Forum 2002 Method I: Equity Price Experience  Deposit insurance can be modeled as a put option on the bank’s assets (Merton, 1977)  Input parameters:  Volatility of equity returns  Bank leverage (market value of equity over debt)  Degree of regulatory capital forbearance  Limited application:  Need market valuation of the bank’s net worth (listed banks in market-oriented countries)

5 Finance Forum 2002 Method II: Default Experience  Expected loss pricing Expected loss=Expected default probability*Exposure*Loss given default  Expected loss = Size of the loss to the deposit insurer as percentage of insured deposits  Expected default probability = The bank’s estimated probability of default  Exposure = Amount of insured deposits  Loss given default (LGD) = Loss to deposit insurer as a percentage of the total defaulted exposure

6 Finance Forum 2002 Estimating LGD  Historical experience of deposit insurer  US FDIC’s historical loss rate equals 8% of bank assets  In developing countries, loss rates of 50 % and up are typical  Good indicators: loan concentration, business mix, structure of bank liabilities

7 Finance Forum 2002 Estimating Default Probability  Historical default probabilities  Implied by historical losses of the deposit insurer  Implied by a bank’s credit ratings on deposits  Implied by a bank’s interest rates on uninsured debt (e.g. interbank deposits, subordinated debt)  p=(y - r f )/(1+y), where p is probability of default on default risky debt, y is the yield on a zero- coupon default risk debt, and r f is the yield on a zero-coupon default risk-free debt (all with the same maturity)

8 Finance Forum 2002 Application: Equity prices

9 Finance Forum 2002 Application: Credit Ratings

10 Finance Forum 2002 Pricing Design Features  Ex-ante funding vs. ex-post funding  Flat-rate premium vs. risk-based premium  Levy on total deposits vs. levy on insured deposits  Broad coverage vs. narrow coverage  Coverage limit  Co-insurance  Include or exclude foreign-currency deposits

11 Finance Forum 2002 Comparing Design Features Design feature  Coverage limit  Co-insurance  FX deposits  Interbank deposits  Funded  Management  Compulsory membership  Risk-based premium  3.2 times per capita GDP  28% of countries  68% of countries  26% of countries  87% of countries  51% of countries public  87% of countries  41% of countries

12 Finance Forum 2002 Insurability  Insurability of a risk is greater if:  Losses occur with a high degree of randomness  Maximum possible loss is very limited  Average loss amount upon occurrence is small  Losses occur frequently  Insurance premium is high  Possibility of moral hazard is low  Coverage of the risk is consistent with public policy  The law permits the cover

13 Finance Forum 2002 Insurance Coverage and Premia  Cost of deposit insurance can be dramatically reduced by reducing the coverage of insurance  Reducing the coverage reduces (at least) proportionally the deposit insurance cost  Reduction in actuarially fair premium could be larger if the reduction in the coverage reduces the asset risk of the bank  Since the per dollar premium is higher with higher asset risk, limiting the coverage has a larger impact on reducing the cost of deposit insurance in developing countries

14 Finance Forum 2002 Risk Diversification and Premia  Non-systemic risk can be diversified away by pooling assets of banks  Potential for risk diversification is larger in:  larger countries; countries with many banks; countries with different types of banks (ceteris paribus)  Price of deposit insurance of a group of banks is lower than the weighted average of the price of deposit insurance for each individual bank  Case-study: Korea. Fair premium (% of deposits):  2.81%, if measured as weighted average of individual premia  1.44%, if measured as a pool of assets

15 Finance Forum 2002 Risk Differentiation and Premia  Exclusion of risky banks can significantly reduce the cost of deposit insurance  Unless some of these banks have great diversification potential  Case-study: Korea. Fair premium (% of deposits):  1.44% (if measured as a pool of assets) – all banks  1.28% (if measured as a pool of assets) – excluding the three riskiest banks (in terms of equity volatility)

16 Finance Forum 2002 Is Deposit Insurance Underpriced?  For comparison purposes, estimated fair premiums should be expressed as a percentage of insured deposits  Estimated fair premiums are higher than actual premiums in many countries – even if estimated on the basis of conservative estimates  On the basis of equity prices:  No capital forbearance: 5 out of 21 countries (24%) underpriced  With 3% capital forbearance: 9 out of 21 countries (43%) underpriced  On the basis of bank credit ratings:  8% loss rate: 5 out of 32 countries (16%) underpriced  50% loss rate: 22 out of 32 countries (69%) underpriced

17 Finance Forum 2002 Pricing the Adoption of Deposit Insurance: The Case of Russia  Alternative methods:  Compare with actual premiums and historical losses in other (comparable) countries  Estimate actuarially fair premium on the basis of the discussed methods  Take design features into account  Estimates of fair premium for Russia are higher than the proposed premium of 0.6% of deposits  Default experience suggests a premium of about 4%  Equity price experience suggests a premium between about 2% and 4% (or even higher depending on the enforcement of capital rules)

18 Finance Forum 2002 Conclusions  Explicit deposit insurance should not be adopted in countries with weak institutional environment  Pricing deposit insurance as accurately as possible is important, but not easy  However, there are several methods that can help in estimating actuarially fair premiums  There exist several design features that can limit the cost of deposit insurance