While a well-designed, limited system of deposit insurance can protect small depositors’ funds in normal times, help to avoid unjustified runs, and provide a framework for the efficient resolution of individual failed banks—thus enhancing systemic stability—a limited system cannot be expected to maintain systemic stability in the face of an unforeseen shock of massive proportions or where weaknesses have been allowed to become so widespread that the system shudders even in response to smaller shocks. Faced with such a scenario and recognizing that financial stability is a public good, the government may decide to take emergency action to preserve the stability of the financial sector. It may also choose to bear the costs of the economic emergency and override the system of limited deposit protection and offer a full, temporary guarantee of depositors and creditors to ensure the continued functioning of the financial system. That guarantee should, however, be removed as soon as possible and replaced by a formal, limited, compulsory system of deposit protection that is funded by the banking system and supported by a good incentive structure, including effective regulation and supervision.
Indications of Systemic Instability
A systemic crisis can be defined in a number of ways. However, following Sundararajan and Balino (1991) and Lindgren, Garcia, and Saal (1996), the phrase is used after the event to refer to cases where there are “runs or other substantial portfolio shifts, collapses of financial firms, or massive government intervention.”69 Ex ante, identifying a system crisis is more difficult.
There are, in fact, a number of indications of problems that are so severe that they cause the government to consider instituting a full guarantee. The typical developing-crisis scenario is one in which insolvencies begin to be perceived by the markets. The crisis will become transparent when liquidity problems occur in individual banks, there is segmentation and eventual non-acceptance in the interbank market(s). customers (both depositors and creditors) withdraw significant amounts of their funds or refuse to renew their contracts, banks engage in distress bidding for deposits.70 the market becomes aware of shortfalls under reserve requirements, and/or banks incur overdrafts at the central bank. Such problems indicate that the system is deteriorating beyond the capacity of the banks to handle their difficulties by themselves and are indicative of an incipient, possibly systemic, crisis that will destroy confidence in the financial system. These problems typically become evident in the operation of the payment system, where risks of disruptions and payment defaults become pervasive. These indications of banks’ insurmountable problems typically become apparent first to large and informed creditors, who tend to run first.
Identifying (in advance) what problem should be regarded as systemic will depend not just on the proportion of banks or bank assets that are in trouble but also on country-specific factors. These factors include, among others, the structure of the financial system, the macroeconomic environment, the state of public confidence in the financial system, and the ability of the authorities to finance and commit to a restoration strategy. As observed in a number of countries, it is not always possible to agree on whether or not a crisis is, or, even after the event, was systemic. It is a judgment call.
Should a Deposit Insurance System Be Introduced in a Time of Crisis?
Should a limited system of deposit insurance be introduced when a country perceives the signs of crisis described above? Or when it fears for other reasons that it might experience a banking crisis? The authorities have considered doing so in many countries, but, as explained above, deposit insurance is no substitute for government support in a systemic crisis. IMF staff advice, therefore, has been not to introduce a limited deposit insurance scheme until the banking system or its major banks have been restructured to acceptable financial soundness that is judged mainly in terms of their solvency and profitability.
Losses are realized when banks fail. To the extent possible, the government should seek to share these losses with owners, depositors, and creditors. Doing so will reduce government outlays and keep moral hazard in check. A limited deposit insurance system facilitates the loss distribution process. However, in cases where the condition of a large portion of the banking system is in doubt and may require large payments from the system, the system will often fall short of resources even if a substantial fund has been accumulated.71 In some instances, the system’s losses will be too large to be absorbed by the banking system even over an extended period of time. While it is true that a system that gives itself or depositors, especially small ones, priority over the assets of a failed bank helps to reduce demands on the insurance scheme, this will not protect it from bankruptcy when bank losses are severe.
Many countries have chosen to provide officially limited, but generous, deposit guarantees, especially in times of crisis. It would have been preferable if they had taken early action to strengthen their banking systems. But some have not done so, so that by the time problems erupt, they believe they must initiate extensive, even comprehensive, deposit guarantees to maintain confidence. Once a generous or full guarantee has been provided, however, it is typically difficult to reduce the coverage to restore market discipline to the financial system. Consequently, countries tend to retain the guarantee and seek to rely excessively on formal systems of regulation and supervision and on other restrictive measures to alleviate the contrary incentives that an excessive guarantee provides. They are, however, unlikely to be successful in strengthening their banking system through supervision alone, especially if systemic bank restructuring has not been undertaken.
Allocating the Losses Caused by Bank Failures
In this situation, the government has a choice—either to absorb the losses itself or to allocate those that have already occurred among the parties involved. (The bank’s owners stand first in line to absorb losses. The holders of subordinated debt are second.) Countries could, but have not explicitly written down banks’ debts. Instead, some have frozen deposits temporarily, reduced the rates paid on deposits, relied on inflation to cut real values, converted private sector claims on banks into long-term bonds or equity, or imposed a special levy on social banks.72
Imposing Special Levies
Before it institutes a full guarantee, a deposit insurer may impose special charges on sound banks. These special charges exceed the regular system premiums in order to compensate the system for the losses incurred by weak banks that it has covered. Special charges, which can extend over a number of years, can be justified, since all banks, including sound banks, benefit from the overall stability in the banking system and from the orderly exit of failed banks. In fact, a deposit insurance fund can itself be regarded as a formalized instrument for all banks to share in funding the losses of weak banks. This loss sharing should not, of course, be allowed to jeopardize the viability of surviving banks.
Should a Full Guarantee Be Provided?
In normal circumstances, the cost of dealing with individual bank failures falls first on the owners and subordinated debt holders, and then on the large depositors, creditors, and the deposit insurance system. Deposit insurance cannot be expected to deal with widespread insolvencies arising from external shocks, major macroeconomic imbalances, or accumulated microeconomic mismanagement. Imposing very extensive special charges on sound banks could destroy them, lead to financial instability and runs on other banks.
Thus, in case of a systemic crisis, the government’s objectives for depositor protection change. There is then a need to protect the payment system and avoid depositors’ “flight to quality,” which may involve a night to cash, other banks, or abroad. In such a situation, the government needs to take control, declare a “state of economic emergency” and possibly establish a temporary resolution authority to deal with the crisis in order to restore confidence and provide a breathing space to make necessary reforms. Thus, dealing with a systemic crisis calls for actions that reach beyond the system of” limited deposit insurance. In a systemic crisis, a full guarantee can he helpful, even essential,73 That opinion has been strengthened by experiences gained during the recent crises in Asia and other countries. For a guarantee to be credible, it must be tailored to recognize fiscal realities. A guarantee by a nearly insolvent government may not be credible and therefore may be meaningless.
Making the Decision
A government has a number of decisions to make when it is faced with a financial crisis. If the government judges the crisis not to be systemic, it will typically use its usual methods of resolving bank weaknesses and failures. If it judges the crisis to be systemic or nearly systemic, it has to consider offering a comprehensive guarantee.
To prevent or control a crisis, the government may decide to extend explicit blanket guarantees to all depositors and also to creditors to maintain confidence in banks and thus prevent a run on banks or the banking system, avoid capital outflows, and aid the economy to recover from the financial shock by ensuring the continuing supply of banking and payment services. This was done in Finland and Sweden in 1992, by Japan and Mexico in 1995,74 by Indonesia, Korea, Malaysia, and Thailand during the Asian crises.75 and also by Jamaica in 1997, Kuwait implicitly in 1992. and Turkey in 1999.
Not all countries that have faced a systemic crisis have granted a comprehensive guarantee, however.76. As shown in Table 4. for example, a number of countries, many in Eastern Europe and the Commonwealth of Independent States did not place a full guarantee when their banking systems experienced systemic problems. This was partly due to a lack of fiscal capacity and partly because depositors were concentrated in the large state-owned savings bank. The government was concerned that a full guarantee would allow insolvent and illiquid banks to bid deposits away from the state bank.
Response to Selected Systemic Crises
Honduras provides government bonds when a deposit exceeds the insurance limit and the assets of the failed bank.
A generous guarantee was given by the Government Bank Insurance Fund. There was not a full guarantee by the government per se.
Response to Selected Systemic Crises
| Countries That Gave a Full Guarantee |
Countries That Did Not Give a Full Guarantee |
|---|---|
| Ecuador | Bulgaria |
| Finland | Czech Republic |
| Honduras 1 | Estonia |
| Indonesia | Latvia |
| Jamaica | Lithuania |
| Japan | Mongolia |
| Korea | Norway 2 |
| Kuwait | Philippines |
| Malaysia | Poland |
| Mexico | Romania |
| Sweden | Russia |
| Thailand | |
| Turkey |
Honduras provides government bonds when a deposit exceeds the insurance limit and the assets of the failed bank.
A generous guarantee was given by the Government Bank Insurance Fund. There was not a full guarantee by the government per se.
Response to Selected Systemic Crises
| Countries That Gave a Full Guarantee |
Countries That Did Not Give a Full Guarantee |
|---|---|
| Ecuador | Bulgaria |
| Finland | Czech Republic |
| Honduras 1 | Estonia |
| Indonesia | Latvia |
| Jamaica | Lithuania |
| Japan | Mongolia |
| Korea | Norway 2 |
| Kuwait | Philippines |
| Malaysia | Poland |
| Mexico | Romania |
| Sweden | Russia |
| Thailand | |
| Turkey |
Honduras provides government bonds when a deposit exceeds the insurance limit and the assets of the failed bank.
A generous guarantee was given by the Government Bank Insurance Fund. There was not a full guarantee by the government per se.
Weighing the Costs and Benefits
The direct and indirect costs of supporting the guarantee can be substantial, but the losses from not doing so can be greater. The guarantee requires providing liquidity to banks to allow depositors and creditors to withdraw their funds at will. The introduction of a comprehensive guarantee should include a conscious decision that the value of maintaining: payment system and the supply of credit exceed costs of providing the guarantee. Opponents of granting a decree will be concerned about creating moral hazard and meeting the potentially large cost of compensating those who are guaranteed. However, a guarantee is most cost effective if it is not used, which requires that the promised coverage be credible. The government or agency that issues the guarantee will need to have explicit legal backing and fiscal resources for the promise to he believable.
The blanket guarantee may have benefits. The losses of banks and the economy in general may be lower, confidence should be greater, both the payment and the financial system should function more efficiently, and the authorities’ responses to the crises should be improved by the greater time available for making good decisions.
A guarantee may be implemented to promote confidence in the financial sector: stabilize the liabilities of guaranteed institutions; gain time to organize and execute systemic bank restructuring: and preserve the integrity of the payment system. A full guarantee may be a necessary condition for containing a financial crisis, but it is not a sufficient one. It cannot restore confidence in a currency crisis or prevent the capital flight that occurs when a country experiences economic or political turmoil, but it can reduce their severity.
Principles to Follow When Offering a Full Guarantee
If it decides that the benefits of providing a blanket guarantee outweigh the costs, the government will provide full coverage. There are certain basic, general principles that it should then observe in granting comprehensive guarantees. For example, full guarantees should not be made a regular part of the financial landscape; otherwise such an action would increase moral hazard. Guarantees should be granted only in economic emergencies to calm the markets and give the government (some) time to study and implement its corrective policies. By not giving explicit guarantees ahead of an emergency, the government is left with flexibility to work out the particular solution that is most compatible with market incentives and the availability of fiscal resources. Sharing losses with creditors and large depositors and closing individual failed banks before the guarantee is given will prove least expensive in the long run
Many of the good practices appropriate in normal times are also relevant during a systemic crisis (Table 5). There are several differences, however. The responsibility may or may not fall to the deposit insurance agency, but it should be clearly defined and publicly understood. The guarantee must be publicly provided to ensure the credibility needed to avoid its being used. Whereas limited coverage should be offered in perpetuity, full coverage must be temporary and must be known to be temporary, to limit moral hazard. This problem must be tackled also by strengthening supervision and regulation.
Good Practices for Blanket Coverage in a Systemic Crisis
Good Practices for Blanket Coverage in a Systemic Crisis
| Good Practice for Deposit Insurance Systems | Good Practices for Full Guarantees | |
|---|---|---|
| Infrastructure | 1. Have realistic objectives. | Have realistic objectives. |
| 2. Choose carefully between a public or private deposit insurance system. | Provide publicly a full guarantee. | |
| 3. Define the deposit insurance agency’s mandate accordingly. | Carefully assign and publicly announce the responsibility for effecting full guarantee. It may or may not be the deposit insurance agency–s responsibility. | |
| 4. Have a good legal, judicial, accounting, financial, and political infrastructure | Have the same conditions, which remain essential. | |
| Moral hazard | 5. Define the system explicitly in law and regulation. | Adopt explicit systems; they are typically more effective than vague implicit guarantees. |
| 6. Give the supervisor a system of prompt remedial actions. | Ensure supervisor retains prompt corrective action. | |
| 7. Resolve failed depository institutions promptly. | Resolve as promptly as is feasible. | |
| 8. Provide low coverage permanently. | Resolve as promptly as is feasible. | |
| 9. Net (offset) loans in default against deposits. | Offsetting past due loans is still appropriate. | |
| Adverse selection | 10. Make membership compulsory. | Blanket coverage is mandatory. |
| 11. Risk-adjust premiums, once the deposit insurance system has sufficient experience. | Risk adjusting remains appropriate where feasible. | |
| Agency problems | 12. Create an independent but accountable deposit insurance system agency. | Design an authority that is accountable and independent, to be in charge of resolving the crisis. |
| 13 Have bankers on an advisory board not dominating the main board of a deposit insurance system with access to government funding. | Not relevant. | |
| 14. Ensure close relations with the lender of last resort and the supervisor. | Ensure that the agency in charge of implementing the full guarantee has close relations with the supervisor. | |
| Financial integrity and credibility | 15. Start when banks are sound. | Start only in a systemic crisis. |
| 16. Ensure adequate sources of funding (ex ante or ex post) to avoid insolvency. | Make sufficient funding available and ensure the public knows this. | |
| 17. Invest fund resources wisely. | Not applicable. | |
| 18. Pay out or transfer deposits quickly. | Provide liquidity to pay out deposits quickly. | |
| 19. Ensure good information | Ensure that those effecting the guarantee have good information to enable them to make wise decisions. | |
| 20. Make appropriate disclosure. | Provide information to the public—it is essential for restoring confidence. |
Good Practices for Blanket Coverage in a Systemic Crisis
| Good Practice for Deposit Insurance Systems | Good Practices for Full Guarantees | |
|---|---|---|
| Infrastructure | 1. Have realistic objectives. | Have realistic objectives. |
| 2. Choose carefully between a public or private deposit insurance system. | Provide publicly a full guarantee. | |
| 3. Define the deposit insurance agency’s mandate accordingly. | Carefully assign and publicly announce the responsibility for effecting full guarantee. It may or may not be the deposit insurance agency–s responsibility. | |
| 4. Have a good legal, judicial, accounting, financial, and political infrastructure | Have the same conditions, which remain essential. | |
| Moral hazard | 5. Define the system explicitly in law and regulation. | Adopt explicit systems; they are typically more effective than vague implicit guarantees. |
| 6. Give the supervisor a system of prompt remedial actions. | Ensure supervisor retains prompt corrective action. | |
| 7. Resolve failed depository institutions promptly. | Resolve as promptly as is feasible. | |
| 8. Provide low coverage permanently. | Resolve as promptly as is feasible. | |
| 9. Net (offset) loans in default against deposits. | Offsetting past due loans is still appropriate. | |
| Adverse selection | 10. Make membership compulsory. | Blanket coverage is mandatory. |
| 11. Risk-adjust premiums, once the deposit insurance system has sufficient experience. | Risk adjusting remains appropriate where feasible. | |
| Agency problems | 12. Create an independent but accountable deposit insurance system agency. | Design an authority that is accountable and independent, to be in charge of resolving the crisis. |
| 13 Have bankers on an advisory board not dominating the main board of a deposit insurance system with access to government funding. | Not relevant. | |
| 14. Ensure close relations with the lender of last resort and the supervisor. | Ensure that the agency in charge of implementing the full guarantee has close relations with the supervisor. | |
| Financial integrity and credibility | 15. Start when banks are sound. | Start only in a systemic crisis. |
| 16. Ensure adequate sources of funding (ex ante or ex post) to avoid insolvency. | Make sufficient funding available and ensure the public knows this. | |
| 17. Invest fund resources wisely. | Not applicable. | |
| 18. Pay out or transfer deposits quickly. | Provide liquidity to pay out deposits quickly. | |
| 19. Ensure good information | Ensure that those effecting the guarantee have good information to enable them to make wise decisions. | |
| 20. Make appropriate disclosure. | Provide information to the public—it is essential for restoring confidence. |
Credibility
Just as a limited system of deposit insurance will not sustain financial stability in a systemic crisis, for similar reasons, placing a full guarantee that exceeds the government’s capacity to pay will not restore confidence in a crisis. Consequently, the guarantee that is given must be tailored to fit financial reality. The tailoring may involve excluding certain classes of institutions, certain financial instruments, or certain classes of creditors from coverage. Those excluded may incur losses
To effect a credible guarantee, the authorities must then choose: (1) when and how to provide the guarantee; (2) which financial institutions to include; (3) which financial instruments to cover; (4) which types of depositors and creditors to protect; (5) in which currency to provide compensation; (6) how to deal with disruptions to the payment system: and (7) what measures to take to ameliorate the moral hazard that the guarantee carries.
How and When Should the Guarantee Be Provided?
The existence and provisions of the guarantee should be precisely specified in emergency legislation or decree, and the terms should authoritatively be made clear to the public. Judging the correct language and tone to use in making the public announcement of the guarantee is crucial to restoring public confidence. While the government may be able to share costs of bank failures at the beginning of a crisis, it foregoes the option to impose losses on creditors and depositors once it has put a full guarantee into effect. Consequently, judging the correct moment to enact and announce the decree is difficult but important for its effectiveness and cost. Placing it too quickly can weaken market discipline in the financial system, while waiting too long can destroy public confidence, which will be difficult to rebuild. Skill is required in judging the optimal timing for placing a full guarantee so that its validity is not called into question and it is not called upon to provide large amounts of compensation to those benefiting from a guarantee that is called or unnecessary comfort if it is not called.
Dealing With Deficiencies in the Infrastructure
The country will need to show that it intends to make progress toward legal, judicial, accounting, financial and political reforms, if its temporary comprehensive guarantee is to be credible. Such reforms are likely to take place over a number of years.
What Should a Comprehensive Guarantee Cover?
Typically a full guarantee covers all bank debts to both depositors and other creditors. (As discussed above, protecting shareholders and subordinated debt holders is inappropriate unless they carry no responsibility for the plight of their banks). It must be decided whether the risks of exchange rate fluctuation and the inflation-induced erosion of real value will be covered.
Which Institutions Should Be Included in the Guarantee?
The authorities must decide which financial functions they seek to protect. Where commercial banks provide the principal means of intermediation and of collecting deposits, make loans, evaluate risks, facilitate the payment system, and transmit monetary policy to the economy, they would be the first candidates for inclusion in the guarantee. As the conjunction of deposit-taking and loan-granting makes institutions vulnerable to runs, other types of depository institutions, such as finance companies, merchant banks, savings banks, and credit unions could also be covered if they operate as near banks and play a sufficiently important role in the financial system and the economy.77 In addition, institutions whose demise could contaminate the banking system should also be included. The composition of the set of guaranteed institutions will vary from country to country with local conditions. Domestic institutions and local subsidiaries, affiliates, and branches of foreign banks would typically be covered.78
When fiscal constraints are compelling, the government may decide to limit the institutions it will cover under the full guarantee to the core banking system in order to control its costs. It would be ill-advised to try to pre-specify which banks will emerge from the rehabilitation process that is to follow as the core banks in the system. To attempt to identify the core would require picking winners and losers in the race for survival, and the government’s choice is likely to differ from the markets’ determination. The core will emerge after the event. By not extending the guarantee to all banks, it needs to be assessed whether those that are not covered will fail; how extensive will be the losses that their creditors incur, and the social, political, and economic implications of these losses. Where compensation is offered, it must be speedy if it is to be credible; otherwise depositors will recognize that they are incurring losses in present value terms. A comprehensive guarantee in nearly all cases is basically a liquidity guarantee, so it must be satisfied on demand.
The decision on which types of institution to exclude would depend on where the government is prepared to impose losses and where it expects contagion to spread. To the extent that it fears runs and flight to quality at home and abroad by large creditors, the government will focus on guaranteeing the institutions that house the funds at risk of flight. To the extent that it is interested in protecting the smaller citizens from hardship caused by the financial crisis, it will also cover smaller, consumer-oriented institutions.
Which Creditors Should Be Protected?
The guarantee will be written in legal language to encompass those creditors whose flight could threaten the banking system. It will most probably protect both the domestic and foreign creditors of banks located onshore. Both large and small depositors and other creditors would be covered under the comprehensive guarantee.79 Depositors and creditors of offshore centers would not be protected if the authorities want to send a message to sophisticated creditors in these locations that they are at risk. Offshore institutions often benefit from minimum regulation and lax supervision, so that investors should assess their exposure to loss accordingly. This will have to be judged case-by-case in view of the importance of the offshore center to the onshore sector. Some countries have chosen also to protect subordinated debt holders, while others, such as Indonesia, Korea, Malaysia, Mexico, and Thailand imposed losses on the holders of subordinated debt.80
Should External Creditors Be Protected?
The issues governing whether and how to cover external creditors are complex. Those countries that have offered guarantees to external creditors have done so in the hopes that the guarantees will increase the confidence of these creditors, who would be encouraged to roll over their loans and not add to the capital flight that may have already occurred. In many cases, however, external creditors have not rolled over their loans, and capital flight has continued.81
This observation raises important questions regarding whether, and to what extent, losses should be imposed on external creditors. This paper does not seek to answer this question, which remains to be resolved as one of the important issues regarding private sector burden-sharing in the context of discussions on the new international financial architecture.
Which Instruments Should Be Encompassed in a Full Guarantee?
A country may formally guarantee only straight-forward deposits, repurchase agreements, senior, and non subordinated debt instruments. In practice, it is virtually impossible to exclude derivatives and other off-balance-sheet contracts, once the institution ceases operations. This situation arises because derivatives often convert into the standard, on-balance-sheet instruments that would be covered by the comprehensive guarantee when one party to the contract defaults.
The Currency of Payment
Most countries that have offered a full guarantee on foreign currency liabilities have made payment in domestic currency valued at the current exchange rate. Korea, however, provided liquidity support to commercial banks in foreign currency.
Dealing with Disruptions to the Payment System
The agency responsible for the integrity of the payment system (often the central bank) can take several steps to reduce the risk of loss, alleviate the domino and contagion effects from the losses that do occur, and curtail the costs inclined by the deposit insurance system and the lender of last resort.
The central bank typically uses standing credit facilities, such as a Lombard facility, or intraday credit accommodation of payments to maintain liquidity in the payment system. Before the full guarantee is given, assisted by the supervisory authority, the central bank should ideally seek to accomplish the difficult task of distinguishing between illiquid and insolvent banks. It would lend to the illiquid but viable banks, and rely on the supervisor to deal firmly with nonviable banks. However, when problem banks are numerous, very large, or cannot be identified ex ante, it becomes difficult for the central bank to contain its lending for fear of triggering a systemic crisis. Before the full guarantee, central bank lending should be temporary, strictly limited, carry an explicit government guarantee.82 and be considered as the first step in a comprehensive financial and operational restructuring.83
Once the guarantee has been given, the central bank must provide the liquidity to honor it. That means providing liquidity first, before the bank’s capital position is known. Capital deficiencies will be dealt with later by the deposit insurance system or in the budget. All concerned, however, need to clearly understand that the central bank has few real resources (capital and reserves) to deal with bank insolvencies, and that the government needs to stand behind all the credits that are extended by the central bank. To the extent that such credits are not repaid, their costs must be borne by the budget and. ultimately, by the taxpayer.
Concomitant Measures to Contain Moral Hazard
Countries have adopted a number of measures to control incentive problems. They include (1) in insolvent banks, writing down the owners’ shares and subordinated debt-holders’ claims and fulls and replacing their management: (2) announcing that the full guarantee is only a temporary measure;84 (3) capping the interest payable on deposits at some market determined rate;85 (4) covering only the principal plus a limited amount of interest: (5) imposing a fee for the guarantee;86 (6) intensifying the supervision of institutions encompassed under the comprehensive guarantee; (7) placing limits on asset growth in individual institutions; (8) ensuring that insiders and criminals are excluded; and (9) temporarily nationalizing banks that are recapitalized with public funds.
As discussed above, writing down the claims of shareholders and subordinated debt holders and replacing faulty management serves as a warning for such stakeholders to conduct their fiduciary stewardship responsibly in the future. Announcing that the full guarantee is temporary warns large depositors and creditors to keep monitoring the condition of their banks so that they can exert market discipline when the guarantee is removed. Capping interest rates and covering only principal plus limited interest both reduce the ability of weak banks to bid for deposits and to use the guaranteed funds so obtained to gamble for recovery or to loot the bank. These measures also reduce the financial obligation that the government must cover. Imposing a fee for the guarantee on all banks reduces adverse selection and helps to pay some of the government’s costs of providing the guarantee. Intensifying supervision is necessary to prevent bank owners and managers from gambling for recovery, looting the bank, and from taking other actions that will weaken their bank.
A number, or all, of these measures are recommended as ways to reduce the much-feared moral hazard associated with granting full coverage. At the same time, moral hazard becomes less of an issue and is more easily managed when the crisis is fully transparent and the public recognizes that, temporarily, exceptional measures are necessary to contain it.
Finally, despite all efforts to follow good practices for installing a guarantee, the credibility of the guarantee will only be as good as the government’s financial position. The government’s solvency and liquidity, in turn, depend on the strength of the macroeconomic. microeconomic, and structural reforms undertaken to resolve the crisis.
On Removing a Global Guarantee
Global guarantees are typically provided in two conceptually different instances: in times of crisis for a wide range of financial institutions and in the normal course of events for state-owned banks. In both cases, these guarantees contain moral hazard, constitute major distortions, and should be phased out as soon as possible to improve the competitive efficiency of the banking system.
The Advisability of Removing Full Guarantees
The modalities of removing a full guarantee are currently of interest to a number of countries. Some countries have introduced a blanket guarantee for bank depositors and creditors during a crisis where there was no explicit deposit protection (as in Indonesia, Jamaica, Malaysia, Sweden, and Thailand) while others augmented the coverage offered by an existing system (as in Finland, Japan, Korea, and Mexico). Finland and Sweden subsequently have replaced their blanket guarantees with limited systems of deposit insurance: and Honduras, Indonesia, Jamaica, Japan, Mexico, Thailand, and Kuwait are preparing to do so.
A number of countries have given full guarantees to their state-owned banks. Some, including China and Costa Rica, are considering removing their full guarantees on state-owned banks. (Kuwait and China’s guarantees are implicit, and Costa Rica’s is explicit.)
Having the full guarantee in place is costly. It may involve explicit outlays and otherwise carry the costs inherent in a contingent liability, see Merton and Bodie. 1993. Whether it is called or not, it reduces market discipline and makes control exercised by supervisors the basic means for limiting perverse incentives. Thus, there is typically a need to scale down the guarantee once the crisis is over. To do so in a credible way normally requires new legislation to provide for the introduction of a limited deposit insurance system and an institutional infrastructure to support it (laws and regulations necessary for corrective actions and exit policies, and institution strengthening and supervision). This is the route that Finland and Sweden followed when they discontinued their emergency guarantees of all bank liabilities after their crises were resolved in the mid to late 1990s and. at the same time, initiated a new or revised system of deposit insurance.
Following necessary restructuring of the banking system, improved macroeconomic policies, and measures to strengthen prudential regulation and supervision, an explicit, comprehensive guarantee should be replaced by a system of limited protection that is the same for large and small banks, whether they are state-owned or private. However, replacing a credible full guarantee with a limited system invites runs when the condition of the banks is weak or unknown. Thus good timing for removing the guarantee is essential.87
Timing the Removal
There is a trade-off with regard to liming the guarantee’s removal. It is possible to retain the guarantee pending the dawn of the perfect day when every conceivably desirable condition has been met. But that day may never come, so it may be preferable to remove the guarantee once a minimum set of conditions has been met. Some countries have adopted an intermediate course of action. They begin to phase out the full guarantee when they believe it will be a nonevent. The phasing out allows public confidence to be tested sequentially. More of the guarantee will be removed as more of the conditions for removal are met and the risk of runs has been reduced. A summary of country practices regarding the removal of blanket guarantees is given in Table 6.
Length of Full Guarantees
Length of Full Guarantees
| Country | Date Placed | Date of/for Removal | Comments |
|---|---|---|---|
| Finland | February 2, 1993. | Removed on December 8, 1998. | The existing system of deposit insurance, in place before the full guarantee, was revised in 1998. |
| Honduras | September 1999. | September 2002. | Government bonds are issued to cover the amount of a deposit that exceeds both the limits of the insurance and the assets of the failed bank. |
| Jamaica | January 1997. | August 1998. | The full guarantee was removed when limited deposit insurance went into operation. |
| Japan | Announced June 1995, enacted into law in June 1996, and reiterated in November 1997. | To be removed in April 2002 | The authorities have delayed the removal of the full guarantee for one year until April 2002. |
| Korea | November 1997. | By December 2000. | The deposit insurance system, enacted in 1996 and overridden by the full guarantee, is to be revised. |
| Kuwait | 1992. | No date has been set for cessation. | The guarantee is has been announced, but it is not written in law. |
| Malavsia | January 1998 | Not yet announced. | There has been some discussions concerning starting a system of deposit insurance to replace the blanket guarantee. |
| Mexico | Unclear, | To be phased out slowly by 2005. | The process of phasing out the full guarantee has already started. |
| Sweden | December 18, 1992, | Was removed on July 1, 1996. | Deposit insurance was started for the first time in 1996 to replace the full guarantee. |
| Thailand | September 1997. | Not yet announced. | The government is preparing a system of limited protection to replace the full guarantee. |
| Turkey | December 1999. | No date has been announced. | The guarantee has been announced but has not been written into the law. |
Length of Full Guarantees
| Country | Date Placed | Date of/for Removal | Comments |
|---|---|---|---|
| Finland | February 2, 1993. | Removed on December 8, 1998. | The existing system of deposit insurance, in place before the full guarantee, was revised in 1998. |
| Honduras | September 1999. | September 2002. | Government bonds are issued to cover the amount of a deposit that exceeds both the limits of the insurance and the assets of the failed bank. |
| Jamaica | January 1997. | August 1998. | The full guarantee was removed when limited deposit insurance went into operation. |
| Japan | Announced June 1995, enacted into law in June 1996, and reiterated in November 1997. | To be removed in April 2002 | The authorities have delayed the removal of the full guarantee for one year until April 2002. |
| Korea | November 1997. | By December 2000. | The deposit insurance system, enacted in 1996 and overridden by the full guarantee, is to be revised. |
| Kuwait | 1992. | No date has been set for cessation. | The guarantee is has been announced, but it is not written in law. |
| Malavsia | January 1998 | Not yet announced. | There has been some discussions concerning starting a system of deposit insurance to replace the blanket guarantee. |
| Mexico | Unclear, | To be phased out slowly by 2005. | The process of phasing out the full guarantee has already started. |
| Sweden | December 18, 1992, | Was removed on July 1, 1996. | Deposit insurance was started for the first time in 1996 to replace the full guarantee. |
| Thailand | September 1997. | Not yet announced. | The government is preparing a system of limited protection to replace the full guarantee. |
| Turkey | December 1999. | No date has been announced. | The guarantee has been announced but has not been written into the law. |
The Ideal Time for Removal
To be certain to avoid disruption to the banking system, the partial guarantee would not be introduced ideally until (1) public confidence has been restored; (2) the banking system has been restructured successfully; (3) the crisis has passed; (4) the economy has begun to recover; (5) the macroeconomic environment is supportive of bank soundness; (6) the authorities possess, and are ready to use. strong remedial and exit policies for banks that in the future are perceived by the public to be unsound; (7) appropriate accounting, disclosure, and legal systems are in place; (8) a strong prudential regulatory and supervisory framework is in operation; and (9) the public has been given adequate notice of the pending change.
These ideal conditions may never be met and there is a danger that the government will prolong the guarantee indefinitely, especially as a number of the conditions will take time to implement. The government must use its judgment that the immediate issues have been addressed and sufficient progress is being made toward achieving the longer term goals. In other words, the guarantee can be safely removed when it is no longer needed and removal is a “nonevent.”88
To avoid premature removal, the supervisory agency and the central bank should both be prepared/required to certify that the financial system is strong enough to withstand the strain of removing the guarantee. This certification must be based on reliable regulatory and market information about the current condition of the banking system and credible forecasts of its future condition. Second, legislation specifying the modalities of the system of deposit protection and efficient bank exit should be in place, and implementation plans should be virtually complete, before the date for removal is announced. Planning the reforms and passing the requisite legislation can easily take more than a year.
Moreover, it would be advisable to have contingency plans in place prior to removal in order to cover an unexpected loss of public confidence in individual banks or an unforeseen deterioration in banking industry conditions. For example, the lender of last resort may have to enlarge its support to help banks cope with transitional difficulties. The authorities should not revert to a full guarantee when faced with isolated banking problems or slow runs that can be dealt with under normal procedures. Instead, they should act decisively to cure ailing banks by prompt, corrective actions and merge, place in conservatorship, recapitalize, or liquidate insolvent banks.
Third, the authorities should be cautious in prematurely announcing a date for removal, especially at the time when the full guarantee is first put in place.89 In fact, it may be necessary to announce a minimum time period during which the guarantee will remain in effect together with a minimum time period that will be given for the removal (as done in Indonesia). Some countries may wish to pre commit to a date for removal to gain maximum credibility and to hasten the legislation and the structural reforms that need to accompany the removal of the guarantee.90 The decision on when to remove a full guarantee must be examined on a country-by-country basis. If a general guarantee seems to stay in place too long, the development of a strategy for removal is imperative.
Recognizing that the guarantee should be removed as soon as possible, but facing a choice between removing the guarantee possibly prematurely and waiting for a very long time for ideal conditions to be met, some countries have chosen to phase out the guarantee over a period of time. Korea did so by reducing full coverage to principal, but not interest, for large deposits in August 1998. Mexico has already embarked on a complex schedule for removing its blanket guarantee by 2005. Sweden and Finland both removed their full guarantees once their financial systems had been restructured and they experienced no adverse effects. Japan initially announced that its blanket guarantee would be removed in 2001, but has subsequently extended the period for one year. Clearly, the authorities should move with determination to reform the financial system where necessary so that the preconditions can be met at the earliest opportunity.
Preparing for Removal
Even where it is not expected that the economy will be ready for the introduction of a system of limited protection for some time (perhaps several years), preparations for the transition need to be made in order to be consistent with the reforms that need to be made to banking and other laws. The date for the removal should be announced ahead of time to give the public time to adjust.
After Removal
After the guarantee is removed, the authorities need to demonstrate their commitment to the new arrangement and their determination not to backslide. A few precedent-setting actions by the authorities after the introduction of the system, such as disciplining troubled banks and resolving failed banks strictly according to the newly instituted rules, could confirm that the authorities will do what they have said they intend to do.
Phasing Out Full Guarantees on State-Owned Banks
A number of countries are currently considering how the authorities should deal with state-owned banks, including commercial, development, and savings banks whose deposits the government guarantees in full.91 Similarly, they are considering whether and how to remove the guarantees on banks that are owned by municipalities or states.
The solution to this distortion is not to extend full depositor protection to other banks, but instead to subject the guaranteed bank to the same limited deposit guarantees (as well as prudential rules and supervision) that other banks receive. Any cutback in explicit deposit guarantees would have to be announced ahead of time and phased in (possibly over a long period) in order not to trigger runs and, possibly, a systemic crisis.
In principle, there should be little hesitation in removing an implicit guarantee for state-owned and privately owned savings banks, especially where that guarantee lacks credibility. But even this situation presents a difficult choice for the authorities, who fear that removing even a shaky guarantee may precipitate runs. As for the removal of an explicit comprehensive guarantee, discussed above, the removal and its replacement with a limited system of deposit insurance needs to be timed correctly. That is, removal should occur after the banking system has been recapitalized and the system of supervision and regulation has been modified. This process can be expected to take time.
Some countries may choose to phase in removal by reducing coverage in successive steps down to the desired limit (Mexico has adopted this strategy). Other countries with a legal system that protects individuals’ existing rights may have difficulty removing an existing guarantee for household deposits. The guarantee could then continue in place until a deposit is withdrawn, whereas new deposits would be insured under the new partial deposit insurance system.92
In some instances, guarantees have been given by other than the national authorities—for example, the state offers a full implicit guarantee for state-owned commercial banks and a local government provides an explicit guarantee for other segments of the industry. Either or both may lack credibility. In this situation, a noncredible guarantee should be replaced by a partial deposit guarantee that is temporarily confined to the relevant segments of the industry. A transfer of a guarantee from local to national authorities is not desirable. In the interim, any full implicit guarantee should remain in place for nationally owned banks until the state banks have been restructured. Then it can, and should, be replaced by a partial system that applies to all banks equally. The recommendations are similar when there is an explicit full guarantee for state-owned banks, but no coverage for privately owned institutions. That is, a limited system should be introduced first for banks with noncredible guarantees while retaining the lull guarantee for state-owned banks until conditions are right for its replacement by the limited system.
Savings Banks
Removal of the guarantee is warranted but less urgent where a savings bank is ahead) operating as a narrow bank that invests in safe government securities. It is less urgent because banks’ yield structures would tend to reflect the different degrees of risk on their deposits. Savings banks with safe assets would pay lower deposit rates and not attract an inordinately large volume of deposits. Nevertheless, it is desirable to phase out such special treatment over time. Moreover, to the extend that a savings bank operates like any other commercial bank, or even transacts in the riskiest segments of the interbank market (as many of the savings banks in the CIS countries do), their guarantee constitutes a major distortion to the incentive and reward structure in place in the financial markets and should be removed as soon as can safely be accomplished.
Conclusions Regarding Removing Guarantees
As said above, a well-designed system of limited deposit insurance can foster stability in normal times. Although a full, explicit, temporary guarantee can be necessary in a systemic crisis, the guarantee should be removed as soon as is safely possible. A full guarantee should not be removed prematurely. When it is replaced by partial system of deposit insurance, small depositors should be covered and market discipline should be exercised by owners, where feasible, by holders of subordinated debt, and by a small number of uninsured large creditors and depositors (such as corporations and other financial institutions), supported by strong supervision and appropriate disclosure rules and internal controls. The option of distributing losses to large depositors and creditors is desirable in view of fiscal resource constraints and the desirability of sending strong signals to the market. Needless to say, this is inherently difficult.