Even though the global financial system is based on fiduciary relationships, it is considered safe and well-regulated. This is advanced by internal rules for bank management, capitalization and liquidity, as well as conduct and systemic risk management. External bank supervision imposes regulatory review, stress testing and requires licensed credit institutions to be part of a local depositor protection scheme. Financial stability is the objective but complete control interferes with self-regulation and the principles of a free market.
Bank deposit insurance is provided to eligible account holders by deposit guarantee schemes. Such schemes protect bank accounts held at supervised credit institutions and therewith protect confidence in and thus the stability of the financial system. It is alleged that creditors are less inclined to overreact and initiate a run on the banks liquidity when their deposits are insured and swift repayment of their insured account balance is guaranteed.
The limit of deposit insurance depends on local characteristics. Purchasing power parity and other domestic economic factors determine the level of protection. These levels are generally capped at two to three times the annual general average income and therewith sufficient to mitigate the risk for retail deposits. The surplus on bank accounts is considered risk capital and subordinated in the creditor or insolvency hierarchy when bank liquidation procedures are initiated.
Membership of a deposit protection scheme is mandatory for licensed deposit taking credit institutions. The compulsory nature of this membership is derived from several frameworks globally referred to as banking law. Similar to traditional insurance, member institutions pay periodic premiums based on the risk profile of their customer portfolio. The fund is used to repay insured account balances to eligible creditors. The fund takes over the claim of the account holder after insurance repayment and reclaims this payment during bank liquidation.
Deposit guarantee schemes are separate and independent agencies. The management board of the scheme is accountable to the minister of finance. Its board members are mostly employed by other government agencies such as the financial regulator, central bank, and/or the minister of finance. The schemes are not financially backed by governments although their mandate is provided in a top-down structure. Several safeguards are however provided to ensure that the applicable deposit guarantee scheme has the power to reimburse claimants when their bank fails and a DGS is triggered.