VoxEU Column Financial Markets

Systemic risk and deposit insurance premiums

Financial institutions enjoy a large number of government guarantees. This column says that we ought to be charging banks for such subsidies and doing so in a way that promotes financial stability. It uses the example of demand deposit insurance in the US to explore the poor design of funding for such guarantees.

We stand at interesting crossroads. Increased financial regulation is coming (Masciandaro and Quintyn 2009). Bold plans are being proposed for:

  • Resolving distress of systemically risky institutions,
  • expanding the perimeter of regulation to hedge funds,
  • setting standards for compensation structures, and
  • enhancing transparency of derivatives and other off-balance-sheet activities.

Will these plans work?

The answer will depend on the details of their execution, yet, one omission is striking even at the blueprint stage. There is little, if any, recognition that a large number of explicit guarantees (subsidies) still exist for the financial sector. These include – most notably – deposit insurance and temporary guarantees for debt issuance, and in some cases, explicitly for asset losses, offered to banks during the ongoing crisis.

Charging the financial sector for these guarantees in a manner that preserves financial stability ought to be on the regulatory agenda. But perhaps it is easier to design regulation than to measure and charge for its costs – direct costs to taxpayers and indirect costs due to induced incentives for banks to take excessive risks. (This column is largely based on Acharya, Santos and Yorulmazer 2009.)

So, here is an attempt to provide a 101 on how to charge for one such guarantee – the government provision of demand deposit insurance to banks, and an assessment of the current scheme for charging of such insurance by one country, in particular, the US. Though our assessment of the US scheme is critical, it must be noted that it is one of the few countries to have in place an explicit deposit insurance fund and to make an attempt to charge risk-sensitive premiums. Many countries such as the UK had offered deposit insurance without the necessary institutional arrangements for its delivery and pricing.

How to charge for deposit insurance

Banks are funded to a large extent by short-term liabilities called “demand deposits” that providers of deposits choose to roll over each day in the sense that they have the right to demand that their deposits be paid back at any point of time. Such demand deposits are explicitly or implicitly insured (up to some threshold per account or individual) in most countries. While regulators in some countries have realised the need to set up a deposit insurance fund only during the ongoing crisis, such funds are prevalent in most developed countries. Furthermore, during the financial crisis of 2007-2009, many countries, most notably Australia and New Zealand, introduced guarantees, whereas a significant majority increased their insurance coverage. The capital of deposit insurance funds – which will be needed in case an insured bank cannot meet its depositors’ demands – is essentially the reserve built up over time through collection of insurance premiums from insured banks.

It would seem natural that much thought must have gone into how such premiums should be charged. It is thus rather surprising that most countries’ funds have no insurance premium being charged and the few countries whose funds do charge a premium (such as the US) do so in a manner that is not sufficiently risk-sensitive and unfortunately pro-cyclical, so that the funds are almost certain to be strapped for capital when insurance claims materialise.

Three simple principles

Given the relatively vast quantity of deposit insurance offered globally to the banking sector without proper charging, we lay out three simple rules for how deposit insurance premium should be charged:

  1. The premium should be sensitive to the risk of individual banks but also to systemic risk; that is, it should increase not only in individual bank failure risk but crucially also in the joint bank failure risk.
  2. The premium for large banks should be higher per unit insured deposit compared to small banks.
  3. The premium should be charged not just to be actuarially fair, that is, to ensure that the fund breaks even on average, but also to discourage moral hazard associated with the insurance. In particular, to discourage banks from herding and creating excessive systemic risk, the premium should charge more for systemic risk than what the actuarially-fair premium would.

Our first and most basic prescription is that the extent of systemic risk in the financial sector is a key determinant of efficient deposit insurance premiums to be charged to insured banks. When a bank with insured deposits fails, the deposit insurance fund takes over the bank and sells it as a going concern or piece-meal. During periods with widespread bank failures, it is difficult to sell failed banks at attractive prices since other banks are also experiencing financial constraints (Shleifer and Vishny, 1992). Hence, in a systemic crisis, the deposit insurance fund suffers from a low recovery from liquidation of failed banks' assets. This, in turn, leads to higher drawdowns per insured deposit.

Second, the failures of large banks lead to greater fire-sale discounts. This has the potential to generate a significant pecuniary externality that can have adverse contagion-style effects on other banks and the real economy (compared to effects stemming from the failure of smaller banks). Hence, the resolution of big banks is more costly for the deposit insurance regulator, directly in terms of losses from liquidating big banks and indirectly from contagion effects.

And third, bank closure policies reflect a time-inconsistency problem (Mailath and Mester, 1994, Acharya and Yorulmazer, 2007, 2008). In particular, the regulators would ex ante like to commit to be tough on banks when there are wholesale failures to discourage them from ending up in that situation. However, this is not credible ex post – regulators show greater forbearance during systemic crises. While such forbearance has featured in the ongoing crisis from most regulators around the world, it has a strong set of precedents.1 However, it is also true that such forbearance is costly ex post, e.g. due to the fiscal costs of government intervention during crises. Such forbearance during systemic crisis creates a collective moral hazard whereby banks have incentives to herd and become inter-connected so that when they fail they fail with others and increase their chance of a bailout (see Acharya 2009 for a fuller description).

Assessment of the deposit insurance premiums in the US

While our three principles to determine efficient deposit insurance premiums apply generally, it is useful to consider them in the context of how premiums have been priced in the United States. To this end, we discuss the Federal Deposit Insurance Corporation (FDIC), the deposit insurance regulator, and the premium schemes that have prevailed so far in the US (this discussion is largely based on Saunders and Cornett 2007, Pennacchi 2009 and Cooley 2009).

As a response to the devastating effects of the Great Depression, the FDIC was set up in 1933 to insure deposits of commercial banks and to prevent banking panics. The FDIC's reserves began with a $289 million capital injection from the US Treasury and the Federal Reserve in 1934. Through most of the FDIC's history, the deposit insurance premiums have been independent of the risk of banks, mostly due to the difficulty in assessing banks' risk. During the period 1935-1990, the FDIC charged flat deposit insurance premiums at the rate of approximately 8.3 cents per $100 insured deposits. However, starting in 1950, some of the collected premiums started being rebated. The rebates have been adjusted to target the amount of FDIC reserves in its Deposit Insurance Fund (DIF).

While the banking industry usually wanted deposit insurance assessments to be set at a relatively low level, the FDIC wanted premiums to be high enough that the reserves could cover future claims from bank failures. In 1980, the DIF was given a range of between 1.1% and 1.4% of total insured deposits. As a result of large number of bank failures during the 1980s, the DIF was depleted and the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 mandated that the premiums be set to achieve a Designated Reserve Ratio (DDR) of reserves to total insured deposits of 1.25%. Figure 1 shows the total insured deposits by the FDIC and Figure 2 shows the balances of DIF and the reserve ratio for the period 1990-2008.

Figure 1. Total deposits insured by FDIC

Source: FDIC.

Figure 2. Balances of DIF and the reserve ratio

Source: FDIC.

The bank failures of the 1980s and early 1990s led to reforms in the supervision and regulation of banks such as the Federal Deposit Insurance Corporation Improvement Act in 1991 that introduced several non-discretionary rules. In particular, it required the FDIC to set risk-based premiums, where premiums differed depending on three levels of a bank's capitalisation (well-, adequately- and under-capitalised) and three supervisory rating groups (rating 1 or 2, rating 3, and rating 4 or 5).

However, the new rules have not been very effective in discriminating between banks and during 1996-2006, over 90% of all banks were categorised in the lowest risk category (well-capitalised, rating 1 or 2). Further, the 1991 legislation and the Deposit Insurance Act of 1996 specified that if DIF reserves exceed the DDR of 1.25%, the FDIC is prohibited from charging any insurance premiums to banks in the lowest category. During the period 1996-2006, DIF reserves were above 1.25% of insured deposits and the majority of banks were classified in the lowest risk category and did not pay for deposit insurance.

The Federal Deposit Insurance Reform Act of 2005 brought some changes to the setting of insurance premiums. In particular, instead of a hard target of 1.25%, the DDR was given the range of 1.15% to 1.50%. When DIF reserves exceed 1.50% (1.35%) 100% (50%) of the surplus would be rebated to banks. If DIF reserves fall below 1.15%, the FDIC must restore the fund and raise premiums to a level sufficient to return reserves to the DDR range within five years.

During the crisis of 2007-2009, the reserves of DIF have been hit hard. The reserves did fall to 1.01% of insured deposits on June, 30, 2008, and they decreased by $15.7 billion (45%) to $18.9 billion in the fourth quarter of 2008, plunging the reserve ratio to 0.4% of insured deposits, its lowest level since 30 June 1993. Indeed at such capitalisation, even relatively small bank failures such as the Silverton Bank in Georgia, Bank United in Florida, and, most recently, the Colonial Bank in Alabama (with respectively around $4 billion, $12 billion and $27 billion in assets) threatened to wipe out the fund’s reserves unless ready buyers were found in the private sector. In the first week of March 2009, the FDIC announced that it planned to charge 20 cents for every $100 insured domestic deposits to restore the DIF. On 5 March 2009, Sheila Bair, the FDIC chair, said the FDIC would lower the charge to around 10 basis points if its borrowing authority were increased. Senators Dodd and Mike Crapo, introduced a bill that would permanently raise FDIC's borrowing authority to $100 billion, from $30 billion, and would also temporarily allow the FDIC to borrow as much as $500 billion in consultation with the president and other regulators.

This discussion confirms our starting assertion that deposit insurance premiums have either been risk-insensitive or relied only on individual bank failure risk and never on systemic risk. Further, even when premiums have been risk-sensitive, the focus has been on actuarially fair premiums. This is reflected in effectively returning the premiums to banks when the deposit insurance fund's reserves become sufficiently high relative to the size of insured deposits.

This kind of premium scheme is simply poorly designed. The FDIC’s returning of the premium to banks when its fund is well-capitalised would be akin to a life-insurer not charging a premium because it is well-capitalised and the insured has lived longer than the actuarial tables would imply!

Further, the returning of the premium makes the FDIC fund’s balance highly pro-cyclical, in that the fund is never well-prepared for a reasonable systemic crisis and it must raise the premium when crises occur rather than in good times when banks would find it easier to pay. Further, the scheme is divorced from any incentive considerations. The rationale for charging banks a premium on a continual basis based on individual and systemic risk regardless of the deposit insurance fund's size is that it causes banks to internalise in good times the costs of their risks (and resulting future failures) on the fund and rest of the economy. Since a systemic crisis would most likely cause the fund to fall short and dip into taxpayer funds, the incentive-efficient use of excess fund reserves is as return to taxpayers rather than to insured banks.

It’s time to measure and quantify systemic risk

While the nature of our three prescriptions for the efficient design of premium schemes is straightforward, in practice, quantifying systemic risk can be a challenge. However, it is time now for academics, practitioners, and policy-makers to rise to this challenge. A recent advance in Acharya, Pedersen, Philippon, and Richardson (2009) provides a measure of systemic risk that would be suitable for revisions to future deposit insurance schemes.


Acharya, Viral (2009) “A Theory of Systemic Risk and Design of Prudential Bank Regulation,” forthcoming, Journal of Financial Stability.
Acharya, Viral, Lasse Pedersen, Thomas Philippon and Matthew Richardson (2009) “Regulating Systemic Risk,” Chapter 13 in Restoring Financial Stability: How to Repair a Failed System, eds. Viral Acharya and Matthew Richardson, John Wiley & Sons.
Acharya, Viral and Tanju Yorulmazer (2007) “Too-Many-To-Fail -- An Analysis of Time-inconsistency in Bank Closure Policies,” Journal of Financial Intermediation, 16(1), 1-31.
Acharya, Viral and Tanju Yorulmazer (2008) “Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures,” Review of Financial Studies, 21, 2705-2742.
Cooley, Thomas (2009) “A Captive FDICForbes, 15 April.
Hoggarth, Glenn, Jack Reidhill and Peter Sinclair (2004) “On the Resolution of Banking Crises: Theory and Evidence,” Working Paper #229, Bank of England.
Mailath, George and Loretta Mester (1994) “A Positive Analysis of Bank Closure,” Journal of Financial Intermediation, 3, 272-299.
Masciandaro , Donato and Marc Quintyn (2009). “Financial regulation: Assessing the Obama administration’s financial supervision white paper,” VoxEU.org, 1 August 2009.
Pennacchi, George (2009) “Deposit Insurance,” Paper prepared for AEI Conference on Private Markets and Public Insurance Programs.
Saunders, Anthony and Marcia Millon Cornett (2007) Financial Institutions Management: A Risk Management Approach, Irwin/McGraw-Hill.
Shleifer, Andrei, and Robert Vishny (1992) “Liquidation values and debt capacity: A market equilibrium approach,” Journal of Finance, 47: 1343-1366.

1 For example, Hoggarth, Reidhill and Sinclair (2004) study resolution policies adopted in 33 banking crises over the world during 1977-2002. They document that when faced with individual bank failures, authorities have usually sought a private sector resolution where the losses have been passed onto existing shareholders, managers, and sometimes uninsured creditors but not to taxpayers. However, government involvement has been an important feature of the resolution process during systemic crises – at early stages, liquidity support from central banks and blanket government guarantees have been granted, usually at a cost to the budget; bank liquidations have been very rare and creditors have rarely made losses.


1,890 Reads