Introduction
Deposit-taking financial institutions serve as intermediaries between the surplus and deficit units of the economy. The intermediation process essentially entails risk-taking, with the risks assuming different forms such as credit operational, liquidity, reputation, et cetera. Because the operations of financial institutions affect all stakeholders including the general public, there is no government that does not utilize various means, both direct and indirect, to minimize any damage that might be inflicted on the rights and interests of depositors as a result of failure of financial institutions. In the past, by closely supervising financial institutions and maintaining strict controls over the scope of their business operations, the government had implicitly safeguarded depositors fund.
More recently however, many countries have adopted deposit insurance or guaranteed deposit systems with a view to explicitly safeguarding the right and interests of depositors, especially small ones. A deposit insurance tie is a financial guarantee to protect depositors, especially the small in the event of a bank failure. By so doing, confidence in the banking system is engendered and the stability of the system facilitated. Deposit insurance serves as one of the complementary measures employed by the monetary authority for effective management and orderly resolution of problems associated with both failing and failed deposit-taking financial institutions. The scheme provides government with a framework for invention and sterilisation of the disruptive effects on the economy of failures of deposit-taking institutions.
Without a deposit insurance system, many countries particularly in Africa extended implicit deposit protection to depositors on a discretionary ad hoc basis. Explicit deposit insurance systems have several advantages these implicit protection schemes. By replacing discretion with rules, explicit spotlight deposit insurance provides a faster, smoother and more consistent administrative process for extending protection to depositors and for protection against bank runs. Although, there are arguments against deposit insurance schemes, on balance therefore merits outweigh the demerits and fore, it is hardly surprising that there is almost unanimous advocacy deposit insurance in developing countries by the IMF, the World Bank and other such policy advisors (McKinnon, 1991)
Explicit deposit insurance schemes have a great potential for enhancing the effectiveness of a nation’s financial system. My presence at your meeting today is to discuss the concept as well as the relevance of deposit insurance in Africa. It is hoped that our discussion will go a long way to shed light on the importance of this unique though relatively new scheme in Africa. It is also hoped that the discussion would encourage those countries yet to embrace the scheme to do so.
In discussing this topic further, the next section focuses on the concept of deposit insurance. After that, I shall discuss the potential roles of deposit insurance scheme. This shall be followed by our discussion on the relevance and desirability of deposit insurance in Africa and experiences from some countries with explicit deposit insurance in place before I conclude the discussion.
8.1 Concept of Deposit Insurance
A deposit insurance scheme (DIS) is a mutual insurance system supported by insured banks and administered either through a government-controlled agency or a privately held one (Fres-Felix, 1991). The agency, guarantees deposits in the insured institutions and stands ready to reimburse depositors promptly in the event of failure of an insured bank. Deposit insurance schemes developed as a result of the need to provide some form of protection to depositors who stood the risk of losing their hard-earned money in the event of bank failures. Coupled with this was the need to insulate the banking system from instability that could result from runs and loss of depositor’s confidence.
The practice of deposit insurance differs from one jurisdiction to another. Over the years however, some best practices have emerged to guide countries that have established deposit insurance schemes or countries wishing to create one. Essentially, the practices of deposit insurance schemes deal. With the issues of ownership/administration membership, funding, coverage, pricing and failure resolution. All these features have been extensively discussed in extant literature.
Deposit insurance was first introduced by some states in the United States of
America (USA) around the 1 840s. However, Norway was the first country to establish a nationwide DIS for its savings and commercial banks in 1921 and 1938 respectively. Finland and the former Czechoslovakia established their in 1924 whilst the nationwide scheme in the USA was established in 1933 following the great depression of that year. In Canada, a compulsory DIS was adopted in 1967 (Leaven 2004). In Asia, India was the first country with a DIS in 1961 followed by the Philippines in 1963. In Africa, the first scheme was established in Kenya in 1985 followed by the Nigerian scheme in 1988.
Deposit insurance differs from general forms of conventional insurance. Commercial insurance, on the one hand, is profit-oriented and only serves to safeguard the property of an individual. Deposit insurance, on the other hand is a safety-net vehicle designed to stabilise financial systems and safeguard the rights and interests of depositors in financial institutions by encouraging cooperation between the government and businesses in relation to the provision of credit. It is not profit-oriented. In addition, deposit insurance also serves to guard against financial loss up to a specified limit. In other words, deposit insurance does not merely passively wait for a catastrophe to happen before providing compensation, but adopts all kinds of preventive measures to promote sound operations of insured institutions. This is where deposit insurance and commercial insurance in general fundamentally differ.
There are basically two types of deposit insurance schemes. These are implicit deposit insurance scheme and explicit deposit insurance scheme. The implicit form is a discretionary approach adopted by government to prop up some failing deposit-taking institutions in the absence of an explicit statutory obligation on the part of government to protect depositors. The government is therefore, at liberty to decide whether or not to grant any relief to depositors and the amount of such relief. The approach is not desirable because it creates uncertainty in the minds of depositors which in turn can intensify runs on other banks.
An explicit DIS is created by a legal instrument. The enabling statute usually states the objectives of the scheme and other operational guidelines relating to such issues as ownership, funding, extent of coverage, membership, supervisory and resolution powers, amongst others. Specifically, an explicit DIS provides a formal framework with clear-cut rules and procedures for providing protection to depositors as well as for assessment and management of failed and failing deposit-taking institutions.
An explicit DIS can be designed as a risk minimizer or as a pay box. It is logical for the administrator of the DIS to want to know and minimize the extent of risk it is exposed to and to monitor the changes in the composition and extent of such risk through close supervision of the insured institution. This is the risk minimization responsibility of the deposit insurer. For effectiveness, the statute establishing the scheme in countries where risk minimisation is the focus of the DIS usually provides powers for supervision the deposit insurer. In some countries, such powers cover on-site examination and off-site surveillance of insured institutions as is the case in Nigeria. The off-site supervision involves the receipt and analysis of Periodic statutory returns from insured institutions to ascertain compliance with prudential standards and other regulations, whereas the focus and scope of bank examination are dictated by the perceived levels of risk posed by the insured institution to the insurance fluid. In developing counties where the quality of information supplied by insured institutions has generally been observed to be low, on-site examination becomes a relevant tool to confirm the accuracy of information contained in bank returns.
In some countries however, the deposit insurer is not empowered to supervise insured institutions, rather the DIS in such jurisdictions operate as a pay- box that is, pays insured depositors in the event of a bank failure. In several African countries, the DIS is designed as a pay box.
8.2 Potential Roles of a Deposit Insurance Scheme
The decision to establish a DIS is usually influenced by the potential roles of the scheme. Some of these roles include the following:
8.2.1 Provision of Deposit Protection to Financially Unsophisticated
Depositors
The less-financially sophisticated depositors are often distinguished by the small size of their deposits. This class of depositors is singled out for protection because they do not have the means and/or capability of carrying out the complex task of monitoring and assessing the condition of their financial institutions. This is often not the case with financially sophisticated depositors with large volume of deposits. A DIS is therefore put in place to address the inequity that exists between financially sophisticated and unsophisticated depositors.
Proponents of deposit insurance argue that it is neither reasonable nor fair to expect unsophisticated individuals to monitor banks whose portfolio of assets consist largely of loans. The costs of monitoring bank for small depositors may outweigh the benefits and therefore, it may be rational for them to not actively monitor the condition of their banks. Instead, ignorant small depositor will seek to protect their interests by withdrawing their deposits whenever they are presented with information that causes them to question the solvency of their banks – that is, they will run on their banks Ignorance by small depositors may also prevent them from distinguishing between good information on the Condition of their depository institution and false rumors hence, they may Participate in runs on solvent banks.
It is however important to indicate that although a DIS protects depositors against the consequences associated with the failure of an insured institution it is not designed to protect banks and/or any other deposit taking financial institution from failing.
8.2.2 Contribution to Financial Stability by Promoting Confidence and the
Stability of the Banking System
This objective is based on a concern that depositors may lose confidence in an institution under certain circumstances. A well designed DIS contributes to the stability of a country’s financial System, A protected depositor is not likely be a panicky One at the lust of a problem in his/her bank. That Such a deposit does not run to withdraw his/her deposit and in the Process Precipitate a run on the bank and con on other banks, ensure banking Stability.
8.2.3 Other Deposit insurance Roles
In addition to the provision of deposit protection to less financially sophisticated depositors and contribution to financial stability by promoting confidence in the banking system, DIS are also designed to play the following roles:
a. Provision of a Formal Mechanism for Dealing with Problem Financial Institutions
A DIS, in conjunction with the other regulatory arrangements, provides government with a formalised mechanism for dealing with problem financial institutions with a view to protecting depositors. The introduction of a deposit insurance system may be linked to a country’s attempt to put in place laws and mechanisms that deal with failed institutions. Experience suggests that the failure of depository institutions must be handled in unique ways to deal with the tendency of troubled institutions to deteriorate rapidly, while minimizing adverse effects on the overall financial system. The introduction of deposit insurance may be linked to the creation of a country’s failure-resolution framework for its deposit-taking financial institutions.
b. Contributing to an Orderly Payment System
Deposit Insurance helps to promote financial stability by contributing to the smooth functioning of the payments system. Depository institutions allow individuals and businesses to save and withdraw money when it is needed. By promoting confidence in the system, deposit insurance facilitates the smooth transfer of deposits between parties.
Some deposit insurance systems are also able to provide a form of short- term financial assistance, which may involve guaranteeing the payment obligations of troubled institutions. Such assistance may help to avoid interruptions in payment and settlement flows. In so doing, such assistance provides time for safety-net participants to devise long-term solutions to resolve troubled institutions.
c. Facilitating the Transition from Full Guarantee to Limited Coverage
Countries may introduce an explicit, limited-coverage deposit insurance system as a way of facilitating the transition away from a full deposit guarantee provided by the government or other public entity. Pull coverage is often adopted if the public-policy objective emphasis is to give the banking system protection against contagious runs. Blanket coverage, on the other hand, is usually applied during systemic crisis that threatens the payments system. To transit from full coverage, deposit insurance systems may allow governments to reduce coverage, and also provide a mechanism for managing the required change in public and market attitudes toward deposit protection.
8.3 The Relevance of Deposit Insurance in Africa
Against the myriad of social, economic, political and other developmental Problems facing the African continent, a pertinent question to ask ourselves is whether the deposit insurance objective of protecting depositors, Preventing bank runs, sustaining confidence in banks and promoting financial stability is relevant in the continent?
Economic literature no doubt, is replete with studies which find significant Contributions of the financial sector to economic development and the Primacy of banking in the financial system. In order to make the needed Contributions to development, banks in particular require deposits which can be described as their life blood. In many African economies, banks are the dominant and the most developed entities in the financial system. In Nigeria for example, banks’ total assets in relation to that of the financial services industry currently stood at over 90 percent.
Whilst there is a clear need for diversification of financial service providers, no doubt, banks and other deposit-taking financial institutions should be encouraged to mobilise more savings for development. In such an endeavour, a scheme to protect small savers who provide the bulk of the funds deserves consideration and adoption. Globally, there is ample evidence to show that the presence of an effective deposit insurance scheme to protect depositors engenders confidence in depository institutions, minimizes bank runs as well as contributes to financial stability. Bank runs are contagious and the most pernicious effect of a panic is that it may result in the closing down of sound financial institutions along with the unsound ones.
One major argument against deposit insurance is the issue of moral hazard. The problem of moral hazard arises from the distortion in incentives induced by deposit protection. The presence of protection could affect the behaviour of the economic agents involved, particularly their willingness to assume greater risk. If deposit insurance is achieved by bailing out banks and their shareholders, shareholders may be subject to moral hazard by betting on the government’s or the insurer’s fund. However, if the deposit protection is structured so that shareholders and managers do not benefit from deposit protection, the introduction of this protection would not increase the moral hazard of bankers. To get the full benefit of deposit insurance scheme, the extent of protection to depositors should be such that allow the DIS to achieve its objectives without inducing significant moral hazard.
Presently, while all African countries license banks and some welcome international banks, only a few countries have established explicit deposit insurance schemes to protect depositors. The countries without explicit deposit protection schemes tend to rely on implicit protection of depositors through bank support to prevent failure. However, the prevention of banking failures is a herculean task. A well-managed bank can fail because of factors beyond the bank management’s control. For example, factors exogenous to the bank such as economic downturn, political upheavals, war et cetera can bring down a bank. If the deposits of such a bank were not insured, government would be forced to use tax-payers money to reimburse the depositors or as had been the case in some African countries in the past, Nigeria included, government could allow the depositors to carry their burden alone.
There is no doubt that the well-being of nations particularly, developing ones like ours in Africa, is critically dependent on its economic growth and development which are in turn, significantly dependent on the stability of the financial services industry particularly, the banking sub-sector. A stable banking system is likely to guarantee a stable financial system given the dominance of banks in many financial systems in Africa. All things being equal, a stable financial system is required for a stable economy in developing our continent, with all its rewards.
8.3.1 Explicit DIS in Africa
In spite of the great potentials of financial sector stability and development held out by explicit deposit insurance schemes, it is still rather unfortunate that only a handful of African countries have the scheme in place. Those countries with no explicit deposit insurance in place often have extended protection to depositors on a discretionary, ad hoc basis. Such absence no doubt, could result into uncertainties in the system concerning when and how a failing or failed bank should be handled.
Presently, out of the over 50 countries in Africa, only eight (8) countries have explicit deposit insurance schemes in place. Table 8.1 below presents some of the features of the schemes in some countries that have explicit deposit insurance schemes in Africa. As shown in the table, the first scheme was in Kenya (1985), followed by Nigeria (1988) and the latest was Zimbabwe (2003).
The agency implementing the DIS in Kenya, the Deposit Protection Fund Board (DPFB) was established in 1985 following the banking crisis of the early 1980s. The failure resolution process under the scheme required that the Central Bank should appoint the DPEB as the liquidator as soon as a winding-up order was made. Thereafter, the responsibility to reinburse the depositors, asset liquidation as well as the payment of dividends becomes that of the DPFB.
In Nigeria, deposit insurance scheme was established in 1988 to strengthen the existing safety-net of the banking system following the adoption of the structural Adjustment Programme (SAP) in 1986. The establishment of the Nigeria Deposit Insurance Corporation (NDIC) marked an important milestone in bank depositor protection in Nigeria. Born during an era of deregulation the Corporation commenced operations in March 1989 with the mandate to maintain stability and public confidence in the banking sector, by guaranteeing payments to depositors in the event of failure of insured institutions as well as promoting safe and sound banking practices through effective supervision. In other words, NDIC was designed as a risk minimizer with powers and responsibilities to insure deposits, supervise insured institutions and provide orderly mechanism for failure resolution.
The Corporation had, since its establishment justified the purpose for which it was set up. The Corporation has on record several achievements that are noteworthy. These achievements relate to activities which can be classified into four, namely: deposit guarantee, supervision distress resolution and other numerous activities undertaken by the Corporation with the aim of insulating the industry from destructive runs and instability.
The Deposit Insurance Board (DIB) was established in Tanzania for the purpose of providing policies for, and managing deposit insurance. The DIB, commenced operation in January 1994. The primary objective of the Board was to protect small savers in the event of bank failure. The DIB collects premiums from members, which should not be less than one-tenth of one percent of the average twelve months of total deposit liabilities prior to the date of the notice served by the DIB for premium collection. The Board also had the duty to provide financial assistance to ailing banks, partake in liquidation and pay-out exercises.
The establishment of the DIS in Zimbabwe came at a time when the macroeconomic environment was showing signs of distress in 2003. Hitherto, a bank had failed and some were placed under curatorship. However, the experience from that failure informed the decision to put in place a system to protect depositors. The DIS in Zimbabwe was being implemented by the Deposit Protection Board (DPB) with the objectives of orderly compensating small savers in the event of a financial institution becoming insolvent and the prevention of contagion or the risk of rumor- driven bank runs. The DIS was run as a pay-box system but with powers to resolve failing or failed banks through structured early resolution.
A well designed DIS is a valuable addition to the financial safety-net. For the African countries wishing to establish a deposit insurance scheme, they could learn from the experiences of these countries. It is therefore my strong believe that a meeting of this nature can provide such an avenue.
The relevance as well as the growing importance of explicit deposit insurance worldwide has led to formation of the International Association of Deposit Insurers (IADI) with the vision of sharing deposit insurance expertise with the world. The IAID was formed in May 2002 in Basle, Switzerland with the objective of contributing to the stability of financial system by promoting international cooperation and interaction amongst deposit insurers and other interested parties. The Association has 25 Founding Members of which two (Kenya and Nigeria) are from Africa. The Managing Director! CEO of the NDIC is a member of the Executive Council and Chairman of the Africa Regional Committee of the Association.
As part of its activities for 2004 and in order to encourage the introduction of explicit deposit insurance scheme (DIS) as well as strengthen the existing DISs in the African continent, the Africa Regional Committee of the IADI organized its first international conference on deposit insurance between W and 23rd of June, 2004 in Abuja, Nigeria. The conference was organised in line with that objective and particularly to share experiences and discuss issues that affect the region with respect to deposit insurance practices. For IADI, institutions can be Members, Associates, Observers or Partners. For interested countries, IADI stands ready to provide invaluable technical assistance. All of you participants are urged to sensitize your institutions to join IADI in one of the categories enumerated above.
8.4 Conclusion
Distinguished Banking Supervisors, the financial environment in recent times has rapidly changed and liberalisation, internationalisation and increasing competition have become the norm in most African economies. From all indications, the erstwhile restrictions in the operations of financial institutions have gradually been lifted with the result that the risks inherent in the financial sector have substantially increased. The implication of this is that there is an urgent need for more African nations to adopt deposit insurance systems not only to protect depositors but also to protect their respective payment systems and economies.
In this discussion, we have presented details, with justifications, of essential components of a deposit insurance scheme. Although deposit insurance was first established in Africa barely twenty years ago, its relevance to the African continent is not in doubt. The safety-net of the DIS adequately complements those of the central bank in ensuring a safe and sound financial system. By protecting depositors, particularly the small ones who are usually ignorant of financial matters, deposit insurance encourages banking habit. This is particularly important in a continent where the informal financial sector looms quite large with a large proportion of currency in circulation outside the formal banking system. By every reason, deposit insurance is very relevant to the continent. It is a necessary accompaniment of a safe and sound financial system that is capable of enhancing development in Africa both socially and economically.
