As the government pushes forward on plans to introduce a deposit insurance scheme that would protect bank depositors from financial institution insolvency and bank runs, one of the central questions is whether or not the premium should reflect the degree of risk that the institution poses to the insurance fund.
The argument for a risk-based premium appears sound. It seems grossly unfair that a bank that exercises prudent management of its customers’ deposits should pay the same rate as one engaged in reckless lending practices likely to trigger the deposit guarantee system. In this sense, a risk-based premium could be expected to encourage and reward banks and microfinance deposit-taking institutions (MDIs) for maintaining liquidity and minimising their risk exposure.
Released earlier this month, the “Financial Sector Development Strategy 2016–2025” outlines the Cambodian government’s plan to develop a depositor protection scheme (DPS) that would insure deposits at banks and microfinance deposit-taking institutions (MDIs).
According to the document, the Ministry of Economy and Finance and National Bank of Cambodia have already established a DPS working group to determine the legal and regulatory framework, as well as the most suitable model, for the proposed deposit insurance scheme. A feasibility study has been commissioned to recommend the organisational structure of a DPS in addition to its coverage and the premium to be levied on banks and MDIs.
Meanwhile, the government is formulating a law to regulate the deposit insurance scheme, with a draft of the legislation expected to be ready for public consultation by 2018.
Yet while most insurance schemes – whether covering automobiles, homes or healthcare – adjust policy rates to risk, independent financial experts have advised against this when introducing a deposit insurance scheme to Cambodia.
David Walker, secretary general of the International Association of Deposit Insurers (IADI), a Basel-based standard-setting body, said his organisation generally encourages countries to implement risk-based deposit insurance schemes – but not in all cases. According to Walker, a differential premium system (DPS) under which lenders with a higher assessed risk have to pay more into the insurance fund is preferable only where a “country has in place an effective regulatory system and an appropriate accounting and reporting framework to support the system.”
According to IADI, roughly half of the deposit insurance schemes in place worldwide use a fixed-rate premium. Often such systems are put in place until conditions permit the graduation to a risk-based system.
“In the specific cases of developing countries that are just introducing deposit insurance, we usually recommend they begin with a flat-rate system,” explained Walker. “Then, once the deposit insurer has become established and is operating well, we would recommend a movement towards a DPS.”
That could be the most sensible course for Cambodia, according to Stephen Higgins, managing partner of investment and advisory firm Mekong Strategic Partners, who says risk-adjusted premiums would add a thorny layer of complexity to any new deposit insurance scheme.
“For it to be successful, it needs to be simple to administer,” he explained. “If you have a risk-adjusted multi-tier system, how do you properly assess risk? What weights do you put on international ownership, level of liquidity and risk processes to name just a few.”
“If you had the international rating agencies in here rating all the banks it would be pretty easy, you could just use their ratings, but we don’t have that benefit,” he added.
One inherent problem with a fixed-rate system is that it is particularly susceptible to moral hazard – the tendency of insured institutions to take on more risk than they would in the absence of insurance. While not all bank failures are the result of moral hazard, risk-based deposit insurance is thought to be more effective at preventing liquidity crunches and bank insolvency.
However, Higgins points out that bank risk is not simply a matter of an institution’s lending practices. Factors also include the size of the lender’s capital buffer, its liquidity profile and whether or not it has an AA-rated parent bank able to quickly inject liquidity in times of distress.
Ultimately, it is the macroprudential policies of the National Bank of Cambodia, including higher capital requirements and incremental increases to the liquidity coverage ratio, which will determine the stability of the financial sector and ensure that banks and MDIs manage their deposits efficiently. A deposit insurance scheme will enhance this stability by providing assurance to depositors that their money is safe, preventing or mitigating bank runs.