More than three years ago the ISET Economist blog discussed the idea of deposit insurance and how this idea may apply to Georgia. Today, the deposit insurance scheme is not merely an abstract idea, but a fast approaching reality. Recently, the Ministry of Finance of Georgia discussed a draft law on implementing the deposit insurance system in the country.
According to the draft, all bank deposits in Georgia will be insured for up 5,000 GEL.
The deposit insurance program comes at a cost for banks. Each commercial bank will be obliged to pay a one-time membership fee. On top of that, they will have to pay a monthly fee equal to a certain percentage of the insured deposits (including both GEL and the foreign currency deposits. The percentage paid on GEL insured deposits will be lower than for foreign currency denominated deposits).
The new draft law does not please all the market players. Predictably, large commercial banks are least enthusiastic about the scheme. The reason they are unhappy is quite clear: as largest deposit takers, they will have to contribute the largest amounts towards the insurance program. Moreover, these banks will be in essence paying for something they were quite confidently “getting for free” all this time – the implicit understanding that the government institutions would, for political stability reasons, step in and rescue large, systemic banks in case of a financial crisis. This understanding was also shared by the National Bank of Georgia, which held the reigns of bank supervision quite tightly in its hands, trying to prevent banks from taking undue risks.
Smaller banks, on the other hand, are more likely to be in favor of the deposit insurance. By lowering the deposit risk, the scheme will allow them to more successfully compete for private deposit funds, at least up to the insured amounts.
In light of this, it will be useful to once again briefly survey the global experience with deposit insurance, as well as the likely outcomes of this scheme for Georgia.
THE GLOBAL PRACTICE
As we mentioned already, the deposit insurance schemes can be either explicit (mandated by law) or implicit (based on a shared understanding between banks and government institutions). The former has already been adopted by nearly by 104 countries around the world. Explicit deposit insurance can prevent, or at least significantly reduce, cases of bank runs, even in the countries with strong financial institutions. Yet, the evidence also suggests that if explicit insurance is not used properly, it can give incentives to private banks to take unnecessary risks and accelerate financial crisis (this predicament is known as a “moral hazard” problem in economics). Interestingly, while in Canada and the United States explicit deposit insurance was in place since the Great Depression, many European countries did not use this type of insurance until the early 1990s. Instead, banks relied on the implicit understanding of government guarantees. Under this type of insurance, a country signals implicit guarantees through certain activities (for example, through Central Bank strictly monitoring banks’ liquidity and risks). In 2008, in the early stages of the global financial crisis, many European countries increase the limits of insured deposits from 20,000 to 100,000 Euros, and for a short period of time some governments were even giving unlimited guarantees, pledging that they will not allow a single bank to fail. The United States Federal Deposit Insurance Corporation (FDIC) also increased the deposit insurance limit from 100,000 USD to 250,000 USD at that time.
Besides influencing incentives, a deposit insurance scheme alters the relative price of lending and borrowing, thus affecting the interest rate spread.
According to empirical evidence (Carapella and Di Giorgio, 2003), the existence of an explicit deposit insurance increases lending and borrowing interest spread in the banking sector across countries. The deposit interest rates go down, as deposits are made safer and hence allow banks to lower deposit rates. What is more interesting is that the interest rates on loans increase as well.
The authors interpret the lending rates increase as the evidence of the moral hazard problem - deposit protection increases incentives for private banks to invest in riskier activities, which, on average, increases lending rates. In support of this hypothesis, Carapell and Di Giorgio find that countries with good financial institutional quality tend to exhibit lower lending and borrowing spread.
More recent work by Deniz A., Asli D. and Min Z. (2013) studied relationship between deposits insurance and bank risk during the recent global financial crisis. According to this study in countries with explicit deposit insurance, bank and systemic risks were lower during the financial crisis. The results suggest that the insurance system offered significant stabilization effects. Moreover, they found that a well-functioning supervision system can alleviate the adverse effects of deposit insurance on bank risk in good times.
WHAT SHOULD GEORGIA EXPECT FROM THE REFORM?
Implementation of the explicit deposit insurance system in Georgia should work to ensure depositors’ confidence and prevent bank runs. Additionally, the lawmakers hope that the insurance will increase the amount of savings in banks, helping solve the long-standing private savings problem in Georgia.
Some clues about the baseline savings behavior of the Georgian population can be drawn from the recent Financial Literacy survey, 2016 (performed by the TBC bank, in cooperation with ISET-PI).
According to the 2016 survey, 35% of respondents managed to save some money during last year. Majority of them (nearly 47%) saved money in cash, and nearly 32% saved money on deposits. These numbers are very interesting for the following reason: a Savings Behavior Assessment Survey performed in Georgia in 2011 found nearly identical results regarding the behavior of people who saved any money – 38% of savers put their money in the bank deposits, whereas 47% saved money elsewhere. The main difference between the 2011 and the 2016 survey is that the percentage of population who saved any money nearly doubled since 2011 (from 16% of respondents to 35%)!
Moreover, the 2011 survey found that 60% of respondents were willing to put money in the bank if deposit insurance were offered. At the same time, 79% of respondents in the 2016 survey said that they are willing to entrust their money to the banks. From these responses it is difficult to judge how much the savings allocation behavior will actually change following the reform, but there are reasons to be optimistic about the effect of the new law in this regard.
Of course, one has to keep in mind that insuring deposits can engender two effects: first, it can reduce the deposit risk (shifting the supply curve of bank deposits to the right – which will lower the deposit rates, but likely increase the volume of deposits). It can also affect the demand for deposits negatively, lowering the deposit rates even further and reducing the volume of deposits (in this case, the deposit insurance fee acts as a tax on banks). As these effects work in opposite directions, it may be unclear by how much the volume of deposits will ultimately change. It will be interesting to observe which effect will dominate in Georgia.
To conclude, the deposit insurance seems to be a positive development and, if managed correctly, can increase savings and investment in the country. The key is to ensure that the system is properly managed.
If a given country cannot guarantee strong banking regulations or a carefully designed deposit insurance with safeguards against risk, in addition to strong financial supervisory body to manage banks and provide resolution to failed banks, then introducing explicit deposit insurance will only be a recipe for disaster. Instead of solving the problem of bank runs, it will invite a host of moral hazard related problems.
Hence, for the National Bank of Georgia and for the Georgian government the hard work of building a reliable deposit insurance program which guarantees a strong and stable financial system is only beginning.
Comments
The article looks at international experiences and draws conclusions for Georgia, missing the fact that due to its geostrategical significance, Georgia is in unique circumstances.
Unlike everywhere else, there is already an implicit insurance in Georgia, not by the government of Georgia but by international organizations. As Georgia is a geostrategical spearhead, the Western bloc does not want a banking crisis to occur here. Moreover, as Georgias banking sector is very small compared to Western standards, it is no big deal to bail out. In 2014, the total assets of Georgian banks amounted to 20 bilion GEL __ less than the assets of a typical local bank in a mid-size European city. When EBRD bailed out TBC, this implicit insurance was activated already.
Hence, the negative side of an obligatory credit insurance, further increasing the spread between borrowing and lending interest rates, may outweigh the advantages in the Georgian case.
We went through this in Hong Kong about a decade ago. In the absence of deposit guarantees, but with rather conservative lending practices and strict regulation, a bank had not failed in Hong Kong since 1991. However the lemming-like desire to follow international trends in the absence of a real problem led government to conclude Other international financial centres have deposit guarantees, we want to be as bright and shiny as everybody else, so we will introduce deposit guarantees....despite the fact that banks in Hong Kong had a massive liquidity surplus, savings rates were sky-high and guarantees made no measurable difference to anything at all, apart from add further cost and admin burden to the financial sector, which was passed on to the customer.
If Georgias banking sector can survive a global financial crisis, a Russian invasion and destruction of the countrys infrastructure, a hydrocarbon price crash, recession in a major northern trading partners economy and a regional currency crisis, without a bank failure within the space of 8 years, then it is obvious that the implicit guarantee system is working and the regulator is doing its job. Why paint legs on snakes and address a non-existent problem?
I dont think that implementing the deposit insurance system will substantially contribute to financial stability in Georgia. The current supervision framework adopted by NBG has proved to be working sufficiently well as it successfully alleviated the risks stemming from the recent depreciation episodes. In this regard, the cost-efficiency of the proposed deposit insurance system might be questioned.
However, there are several benefits that can be brought about by deposit insurance in the right hands. Firstly, as it was also claimed in the blog, the system can potentially stimulate savings. The banking system can use the deposit insurance as an advertising tool to persuade the private savers that their money is indeed safe with them. Given the financial literacy level in Georgia, for an average saver the governments promise is a more plausible guarantee rather than Basel III provisions.
Secondly, deposit insurance can contribute to combating the severe problem of dollarization in Georgia as long as the insurance covers only local currency denominated deposits. This way it will stimulate saving in GEL and gradually reduce the financial dollarization level.