Chapter 16: Learning Objectives  Origins & Principles of Deposit Insurance in Canada  The CDIC: Structure & Operations  The International Experience with Deposit Insurance  Policy Issues: Moral Hazard, Adverse Selection & Government Intervention

Origins and Purpose of Deposit Insurance  Fear of systemic bank failures and the externalities involved led many governments to introduce different forms of deposit insurance  opposed by Chartered banks  The CDIC is the institution responsible for administering deposit insurance most financial institutions participate and there is involvement by the BOC and the Finance Dept How are bank failures resolved? –Pay off depositors –merger (forced or voluntary) –transfer to another financial institution –bailout

Deposit Insurance Operation (cont’d)  What is covered by deposit insurance? Table 16.1 $CDN deposits of 5 yrs or less Money orders, travelers’ cheques limited number of RRSPs, RRIFs liability limited to $60,000 BUT a variety of loopholes exist to effectively increase protection –joint accounts –multiple deposits at different institutions –provincial supplementary plans  How is it financed? Flat fee at first, but risk based premiums now in place

Deposit Insurance in Other Countries  Canada was not the first to offer deposit insurance  Deposit insurance elsewhere motivated by different considerations  Not all are purely public plans  There exists a wide variety of plans, premiums, and coverage types Table 16.2

The Problem with Insurance: Moral Hazard  Asymmetric Information means that insured (i.e., banks) knows more about own risks than institutions who insure (CDIC)  As a result, institutions are effectively shielded from risk-taking resulting in more risk-taking than would otherwise be the case [MORAL HAZARD]

The Problem with Insurance: Adverse Selection  The availability of insurance means that individuals are less prone to assess the risk- return relationship and will maximize return (monetary & non-monetary) regardless of risk  The probability of bank failure is changed by the behaviour of depositors who are influenced by the presence of deposit insurance [ADVERSE SELECTION]

Moral Hazard : A Graphical Exposition Legend: H=high risk; L= Low risk Simplified version of Figure 16.1(A) HL Before Deposit Insurance H L With Deposit Insurance

Adverse Selection : A Graphical Exposition Legend: H=high risk; L= Low risk Simplified version of Figure 16.1(B) Depositors View Insurer’s View All banks H L

Should Government Run Deposit Insurance? YES NO To prevent market failure exacerbated by the “externalities” problem Should be treated like any other form of insurance

Can the Existing Deposit Insurance System be Improved?  Insure only minimal number of deposits  risk-based premiums: a version introduced in Canada  improved corporate governance  voluntary CDIC membership  money market mutual funds: a version in existence in Canada

Summary  Insurance against depositor loss is called deposit insurance  CDIC administers deposit insurance in Canada  International comparisons show that deposit insurance is administered in a wide variety of ways across countries  All forms of insurance suffer from the twin problems of moral hazard and adverse selection  Recent policy discussions have focused on who should run deposit insurance and the role of government