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 $100,000 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

Deposit Insurance Around the World

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)

H L

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 failureexacerbated 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