Bank deposit insurance provides a safety net for account holders when financial institutions are in difficulties and are unable to return deposits to customers on demand. Even though the terms and scope of such Deposit Guarantee Schemes (DGS) may differ from country to country, the objective is always the same. A DGS avoids unrest and stimulates public confidence by prompt repayment of eligible and insured back account balances in financial distress.
Eligible account holders have their assets protected up to a maximum balance announced in advance. This protection can best be compared with a standard insurance policy. When the unexpected yet insured event takes place, the insurance policy pays out to the insured persons. Verification of a claim takes place prior to reimbursement. So far so good. The main difference though is that the premiums of an insurance policy are paid by the insured person, where contributions to a deposit guarantee scheme are made by financial institutions with a membership to the scheme.
Participation in and membership of a deposit guarantee scheme is mandatory for credit institutions. The term credit institution refers to a business that accepts deposits or other repayable funds from the public and grants credit for its own account to borrowers. Risk of borrower default is secured by leveraged securitization and based on the assumption that the unlikely and uncommon event of failure to repay credit is incidental and does not occur for all borrowers at the same time.
Bank risk management starts with minimum capital requirements, internal controls and external supervision. As the global financial crisis revealed, risk management and transparency alone is not enough. Additional safeguards, such as deposit insurance are needed to absorb shocks when sector wide economic decline places the financial industry at risk. Regulators then need time to restructure the industry while maintaining public confidence and securing stakeholder interest and assets.
To make a long story short, financial institutions that provide credit are required to participate in a deposit guarantee scheme. Depending on the type of the scheme and its applicability, a membership or entry fee is paid complemented with annual premiums. The premiums are divided in ordinary contributions in proportion to the number of covered deposits by the member institution, and risk-based premiums based on the risk profile and impact of a portfolio on the deposit protection fund. Additionally, these contributions are based on the phase of the economic cycle and the exposure and impact their failure might have on the deposit protection fund and its members.
Financial institutions in distress may qualify as higher risk to the fund. The DGS administrator can thus decide to raise the contribution to the fund of such a member. However, when the financial institution fails or is likely to fail, contributions to the fund are stopped. Reimbursements are made out of the fund and under normal circumstances, the fund takes over the position of the creditor in future proceedings such as the bank liquidation.