Situational Analysis: Conditions and Implementation Considerations

It is important to conduct a comprehensive situational analysis when considering the introduction of a deposit insurance system or when planning to alter an existing deposit protection arrangement. In conducting such an analysis, the economic and institutional conditions and their effect on the alternatives available for a deposit insurance system must be considered. Among the conditions that should be taken into consideration are the state of the economy including, current monetary and fiscal policy; the state and structure of the financial system; the legal framework; the state of the regulatory and supervisory systems; and accounting and disclosure regimes. Although it is understood that in many cases conditions are not perfect, it is important to have a process to evaluate the alternative deposit insurance systems available and how these alternatives are affected by the economic and institutional structure of the country. Through a situational analysis, gaps between existing conditions and more-desirable situations can be identified. SITUATIONAL ANALYSIS: CONDITIONS AND IMPLEMENTATION CONSIDERATIONS This paper emphasises the importance of conducting a comprehensive situational analysis when considering the introduction of a deposit insurance system or planning to alter an existing deposit protection arrangement. In conducting such an analysis, the economic and institutional conditions and their effect on the alternatives available for a deposit insurance system must be considered. Among these conditions are the following: the state of the macroeconomy, current monetary and fiscal policy, the state and structure of the financial system, the legal framework, the strength of prudential regulation and supervision, and accounting and disclosure regimes. Although in many cases conditions may not be perfect, it is important to have a process to evaluate the alternative deposit insurance systems available and how these alternatives are affected by the economic and institutional structure of the country. Through a situational analysis, gaps between existing conditions and more-desirable situations can be identified. To better understand the process, the experience of countries that have considered adopting, or significantly altering, deposit insurance systems were analysed. In addition, consideration was given to understanding the relative importance of these conditions and whether there are some basic criteria that should be satisfied before adopting a deposit insurance system. Alternatives for Deposit Insurance Systems The first step in establishing or significantly modifying a deposit insurance system is for policymakers to determine their public-policy objectives. Policymakers then face a wide range of possible alternatives for the design of a deposit insurance system. These include: the structure of the organisation—public, private, or jointly-administered systems; and the basic powers—paybox systems, which reimburse depositors on the instruction of another authority, or risk-minimising systems with greater capabilities to assess and manage risks. Policymakers should seek to ensure that an effective deposit insurance system is instituted, consistent with both the country’s economic and institutional settings and aligned with the public-policy objectives they are attempting to achieve. 1 The Subgroup members are the International Monetary Fund (coordinator), Argentina, France, Mexico, and The World Bank. 2 As described in the paper on public-policy objectives, there is a wide range of more specific formulations that fall into these categories. 3 See papers on: membership, coverage, funding, reimbursing depositors, depositor priority and rights of set-off, structure and organisation, interrelationships, and powers. Methodology to Analyse the State of Country Conditions The methodology to assess the state of country conditions flows from the Strategic Analysis Model, which begins with the determination of the public-policy objectives, including the key attributes of the system desired. After the public-policy objectives have been identified, policymakers should conduct a situational analysis of the conditions in their country. These conditions include: the macroeconomic environment, including current monetary and fiscal policy; the soundness of the financial system; the state of the legal, regulatory and supervisory systems; the quality of accounting; and the state of the disclosure and auditing regimes. The analysis should expose the strengths, weaknesses, opportunities and threats related to the conditions, and identify any changes necessary for the construction of an effective deposit insurance system. If existing conditions are incompatible with the public-policy objectives, then either the objectives will have to be modified or different options for the design or structure of the deposit insurance system should be explored. Following the development of publicpolicy objectives that are aligned with the country's economic conditions and institutional framework, the next step is to develop a strategic plan for implementation. Analysis of Conditions Macroeconomic conditions An important consideration in a situational analysis is the macroeconomic condition of the country, including its current monetary and fiscal policy. This is important since the macroeconomy can affect the financial system and influence the effectiveness of the deposit insurance system. Although macroeconomic stability is important for the successful implementation of a deposit insurance system, the boundaries between propitious and unpropitious macroeconomic conditions may be difficult to determine a priori. Concerns about macroeconomic conditions often result in a loss of confidence in the entire financial system, which is difficult to restore through a single instrument such as deposit insurance. A loss of private-sector confidence is likely to result from the overall economic situation and the policy stance of the government, rather than more-narrow concerns about the state of the banking system. The introduction of a deposit insurance system, by itself, to protect depositors cannot address the basic causes of the macroeconomic deterioration. A deposit insurance system by itself cannot prevent a banking crisis, or cure one that has already begun. If introduced prematurely, a deposit insurance system can become so discredited that its reintroduction may be impractical when macroeconomic conditions are more favourable. 4 The Strategic Analysis Model was developed to assist policymakers in the design of an effective deposit insurance system. See the Financial Stability Forum Working Group on Deposit Insurance, A Consultative Process and Background Paper, June 2000. If the economic system is relatively stable, then the introduction or enhancement of a deposit insurance system is more likely to be effective in strengthening public confidence. That is, the failure of one depository institution will not necessarily spill over and affect public perceptions about the soundness of other depository institutions. State of the financial system A situational analysis will require an assessment of the soundness of the banking system, including a detailed assessment of the condition of the depository institutions within that system and the extent of their problems. Factors that should be analysed include: capital, liquidity, credit quality, and risk-management policies and practices. An assessment also should be made as to whether these problems are confined to individual institutions or are likely to be systemic in nature. The issue is not whether there are unsound depository institutions in the system, but whether the banking system as a whole is sound. The establishment of an effective deposit insurance system is much more difficult if underlying fundamental financial-system stability issues have not been addressed. Early introduction of a deposit insurance system, for example, could result in incentives for insolvent and illiquid depository institutions to compete for deposits by raising interest rates. Depositors, unconcerned about the financial health of the depository institutions because of the deposit insurance system, may shift resources from relatively risk-averse depository institutions to those adopting more-risky policies. This shift could increase the eventual cost of restructuring. It also is possible that policymakers, when faced with an insolvent banking system, may wish to combine the introduction of a deposit insurance system with a wide-ranging program of banking-system restructuring. Moreover, it is important to be aware that deposit insurance, even when introduced at an appropriate time and in a well-designed form, cannot address all stability issues. Deposit insurance is one element in the financial safety net, which also includes a lender-of-lastresort facility and good supervisory and regulatory practices. If introduced in a coherent fashion, a deposit insurance system can be an important pillar of the restructuring program. If introduced in isolation, however, a deposit insurance system may not be effective. Market-based versus state-directed financial intermediation In undertaking a situational analysis of conditions in a country, policymakers need to consider whether financial intermediation is market-based or state-directed. When 5 A distinction should be made in this analysis between the introduction of an explicit deposit insurance system and the introduction of blanket guarantees for all creditors, including depositors. Under conditions of extreme macroeconomic instability, when depositors are shifting out of the national currency and into a foreign currency held outside the banking system, a blanket guarantee, adopted in conjunction with a broadbased stabilisation plan, can strengthen confidence in the banking sector. However, there are substantial trade-offs in terms of increased moral hazard associated with blanket guarantees. See the paper on moral