Background To The Deposit Insurance Scheme
Following the passage of the Deposit Insurance Act by Parliament in March 1998, the Jamaica Deposit Insurance Corporation formally commenced operation on August 31, 1998.
Formal deposit insurance schemes now exist in almost all developed countries and an increasing number of developing countries. It serves a number of important economic and social objectives, the principal being the provision of protection to small unsophisticated depositors, the maintenance of confidence in and stability within the financial sector and the acceleration of the process of failure resolution strategies in cases where a bank fails.
Deposit Insurance: Definition & Objectives
Deposit Insurance is a guarantee that all or a limited amount of the principal (and in some cases interest accrued on deposit accounts) will be paid in the event that a bank fails. The guarantee may be either explicitly given in law or regulation, offered privately without government backing or may be inferred implicitly from the verbal promises and/or past actions of the authorities.
In recent years, many nations have adopted or are considering a system of explicit or formal system of deposit insurance. Prior to the introduction of a formal scheme, several countries, including Jamaica, would have been operating an implicit deposit protection system whereby Government’s protection of depositors is totally discretionary.
The decision to establish an explicit deposit insurance scheme is usually influenced by a number of considerations. There are three main objectives of deposit insurance, particularly as they relate to our situation in Jamaica.
Firstly, deposit insurance is intended to provide protection to the small unsophisticated depositor who is not in a position to assess the risks of the institution in which the depositor chooses to put his or her savings. This is so either because depositors are not generally able to undertake such risk assessment or there is insufficient information available to them, even if they were able to do so.
Secondly, a deposit insurance scheme will assist in the restoration and maintenance of confidence in and stability of deposit-taking institutions. It will, in achieving this objective, reduce the probability of contagious deposit runs on these institutions which could jeopardize the health of the financial system as a whole.
Thirdly, the scheme will, in conjunction with the Supervisory and Regulatory authorities, provide the Government with a more formal mechanism for dealing with problem financial institutions, with a view to protecting depositors. The scheme will replace discretion with an established legal regime, thus allowing for a faster, and more consistent administrative process.
A formal deposit insurance scheme will also allow for easier quantification of potential liabilities than under an implicit guaranteed arrangement. It was also recognised that the provision of full guarantee of deposits was potentially more expensive than an explicit scheme which would provide limited protection in the event of bank failures.
Developments Leading Up To The Passage Of Legislation
In September 1995, the Government established a Task Force to identify the main policy issues and legislative requirements and to make recommendations for the introduction of an explicit deposit insurance scheme in Jamaica. This initiative came against the background of evidence of financial instability and the increased vulnerability of banks in a liberalised economic environment and the need to provide some form of protection to depositors, especially the smaller ones. Given these trends, the regulatory authorities were of the view that a formal deposit insurance scheme should be established to provide stability and safeguard depositors’ interest in cases where financial institutions experienced difficulties and had to be closed. Technical assistance on the modalities for setting up the scheme was sought from the International Monetary Fund (IMF) and a Mission visited Jamaica in May 1995. The Mission presented their report in July 1995 which outlined various options which could be pursued if Jamaica decided to establish a deposit insurance scheme.
In the formulation of the work plan, the Task Force identified four (4) distinct phases of activities to render the scheme operational. These were as follows:
Phase I: Review and Clarification of policy Issues
· Objectives of the scheme
· The relationship between the Bank of Jamaica and the deposit insurer
· Financing of the scheme and premium assessment
· Governance of the scheme
· Scope and level of coverage
· Granting and termination of insurance
· Powers of the Corporation
Phase II:
· Operational Issues Requiring Legislative Provisions
Phase III:
· Establishment of the Corporation / Scheme
Phase IV:
· Implementation Strategy
To acquire background information on the operational modalities and legislative underpinnings of deposit insurance, the Task Force conducted an examination of deposit insurance schemes in the United Kingdom, Hungary, Nigeria, the USA, Canada and Trinidad and Tobago. Senior officials of the Canada Deposit Insurance Corporation provided invaluable assistance to the Task Force throughout all the phases of the work plan. Phase 1V of the work plan has entailed a massive public education programme to inform the public about the scheme and the responsibilities of depositors.
The Task Force completed its assignment and reported its findings and recommendations to the Government in April 1996. The main operational issues requiring legislative provisions were identified, and on that basis, Cabinet issued drafting instructions for the appropriate legislation to be prepared. On April 29, 1997, a Bill entitled, "The Deposit Protection Act" was laid on the table of the House of Representatives. The Bill was subsequently referred to a Joint Select Committee for examination. Following the dissolution of the previous Parliament, the Bill was laid again on the table of the House on February 3, 1998, and referred again to a Joint Select Committee which completed its deliberations on March 5, 1998. The report of the Joint Select Committee was tabled in the House on March 10, 1998. The Bill, incorporating 60 amendments, which emanated from the deliberations of the Joint Select Committee, was passed by the House of Representatives and the Senate on March 24 and 27, 1998 respectively.
The provisions of the amended Bill (i.e. the Deposit Insurance Act, 1998) reflect some of the earlier recommendations of the Task Force and the deliberations of the Joint Select Committee. Among the fundamental policy decisions which emerged from the discussions and debates prior to the passage of the legislation, were:
i. That membership in the scheme should be compulsory for all deposit-taking institutions supervised by the Bank of Jamaica.
ii. That the scheme should provide for limited coverage, and prompt payment to depositors when a bank fails.
iii. That the Deposit Insurance Fund (DIF) should be primarily financed by initial and annual premiums paid by institutions covered by the scheme.
iv. That the scheme should be independent in its operations and administration, but in carrying out its functions, the Corporation should work closely with the Bank of Jamaica in order to avoid any unnecessary duplication of activities. The Corporation should only be responsible for the provision of deposit insurance and should not act as a regulator or supervisor of banks; and
v. That the Corporation be vested with the necessary powers to mange its affairs.
The above decisions constituted some of the main elements in the design of an incentive compatible or balanced system of deposit insurance. The compulsory nature of the scheme was intended to avoid adverse selection, whereby only high-risk institutions would elect to join the scheme. Such a system would therefore produce a two-tiered banking system - with one segment protected and the other unprotected. During a banking crisis, depositors may transfer their deposits from unprotected to protected banks. These deposit shifts could be large and may put considerable strain on the lender of last resort (i.e. the Central Bank).
Limited coverage will avoid conveying the wrong impression to large depositors - that they can afford to ignore the condition of their bank. Unlike small depositors (the majority of whom the scheme is designed to protect), large depositors have the resources to monitor the condition of their banks. It was agreed that a modest level of coverage both in nominal and real terms would minimise the cost of protecting large depositors while contributing towards a satisfactory level of market discipline. It is for these reasons that the level of insurance coverage was originally $200,000 per depositor. This limit represented just over two times Jamaica’s per capita GDP and satisfied the conventional maxim that coverage should be about twice a country’s per capita GDP. The decision on the level of coverage was also influenced by the size distribution of deposits in commercial and near banks, and building societies.
The decision to establish a Deposit Insurance Fund from the premium contributions of institutions to be covered by the scheme was undertaken with a view to remove some of the financial burden for depositor protection from the Government’s budget to the banking system. The income generated from investing premium contributions would increase the available resources to honour claims, and if the Fund is built up over time to an adequate level, consideration could be given for the premium paid by member institutions (i.e. policyholders) to be reduced.
Although the Act provides for imposition of risk-based or differential premiums, the decision was taken to commence with a flat-rate premium because it is easier and simpler to apply. The majority of countries have opted for this approach despite its drawback in terms of applying the same assessment rate for all institutions irrespective of their risk profiles. Only a few countries, including the USA (since 1993) have introduced risk-based premiums, while Canada is expected to introduce differential premiums in 1999.
Three types of explicit deposit protection arrangements/options were considered, namely:
i. Purely government-owned and administered with funding solely from the Government;
ii. An autonomous corporate entity either wholly or partly funded by the institutions with its own Board of Directors having legal status and established under Statute; and
iii. Jointly administrated but representatives from the deposit-taking institutions and the Government and funded by the institutions.
The decision to adopt option (ii) was based on the following considerations:
· Option (i) has the highest potential for reducing market discipline and encouraging moral hazard. This is so because the institutions are not obliged to share the cost of resolving failed banks. The problem of moral hazard arises from the distortion in incentives induced by deposit protection, whether implicit or explicit. In other words, the guarantee may encourage bankers to assume greater risk and depositors not to discriminate between safe and unsafe banks.
· Options (ii) and (iii) place part of the burden of bank failures on the institutions, but in the case of option (iii) the inclusion of representatives from the industry may lead to conflicts of interest in assessing and approving applicants for deposit insurance, the monitoring of problem institutions, and intervention and failure resolution strategies.
· Option (ii) provides a credible guarantee since the Corporation has the power to borrow from Government where necessary, and as such, would bolster confidence the scheme.
So that the Corporation can conduct its affairs efficiently and achieve its objectives, it is vested with certain powers relating to the performance of its functions, and specifically to undertake measures as may be necessary to minimize its exposure to loss. These include powers to act as receiver or liquidator of any policyholder, and to arrange for the restructuring of a policyholder whether by merger or acquisition by another institution. In order to assist in monitoring risks to the Deposit Insurance Fund, the Corporation is also entitled to receive from the Bank of Jamaica upon request, information relating to the safety and soundness of policyholders.
The deposit insurance scheme should not be viewed as a substitute for adequate regulation and supervision, or as a panacea for problems in the banking sector which may emerge from time to time. The authorities took note of the fact that the problem of a moral hazard would arise if the scheme was introduced without being accompanied or preceded by improved regulations and supervision, and procedures to facilitate the exit or restructuring of failed institutions. Towards this end, the authorities took steps to strengthen the supervisory capacity of the Bank of Jamaica through increased manpower and training. Significant amendments were also made to the governing legislation of all deposit-taking financial institutions in December 1997.
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