Financial Institutions - Chapter 20: Deposit Insurance

What is the nature of liquidity risk

The risk of being unable to turn assets into cash, or raise cash when needed without loosing value

What is the sequential service rule of demand deposits?

They are serviced on a “first-come, first-served” basis. If depositors ask for their money back, in the absence of deposit insurance, they would receive their money in order of request.

Why are banks largely exposed to liquidity risk?

60-65% of liabilities are represented by deposits, specifically demand deposits. Abnormally large deposits drains may result from concerns about solvency, failure of another bank and changes in investor preferences.

What are demand deposits?

Deposits that can be withdrawn immediately, on demand, without advanced notice. However, they are quite stable under predictable situations.

Briefly explain what bank runs are and how they can be prevented

Bank runs are when many depositors try to withdraw their money from the bank all at the same time because they are afraid of the bank failing. They can be prevented through Bank of Canada advances and Deposit Insurance.

Why should depositors implement insurance?

• To protect depositors from a loss due to a FI insolvency

• To protect FI’s from bank runs and insure the stability of the financial system

• To promote competition among FI’s. In the absence of deposit insurance it will be difficult for new banks to attract depositors.

What are the two main issues that arise from deposit insurance?

• Moral hazard: If depositors know their deposits are protected up until a certain level, they have no incentives to monitor their bank

• Trade-off of safety and efficiency: Do we not have deposit insurance and run the risk of bank failures or do we have deposit insurance and create more hazard?

Identify the three methods to minimize risk taking and moral hazard

• Stockholder methods

• Depositor methods

• Regulator methods

How is the stockholder method used to reduce the risk of moral hazard?

This method is related to increase capital requirements and establish premiums that are based on the riskiness of the activities. There are four premium groups based on their risk profiles, and premiums vary. Additionally, if banks have more capital at stake, they are more reluctant to partake in risky behaviour.

Briefly explain the significance of depositor discipline in reducing the risk of moral hazard

• Level of coverage: Depositors are covered for $60,000-$100,000 of deposits

• Co-insurance: Share the coverage between depositors and insurers. Example, CIDC would pay 90% and depositors cover 10%

How is regulatory discipline used to minimize moral hazard risk?

• Promotion of standards

• Monitoring of members

• Disciplinary action: Impose stricter DI closure rules and capital forbearance vs early intervention

How is a bank closed?

Through four different methods involving termination of deposit insurance. Depositors will no longer be interested in doing business with a bank that isn’t covered by deposit insurance

Briefly explain the payoff method of terminating DI for a failed bank

The payout of a failed FI’’s insured deposits and liquidation of it's assets. The CDIC pays the insured depositors up till their deposit level and assumes their claims against the assets of the failed bank. It acts as an unsecured depositor

When is the payoff method typically used?

This method is usually used for smaller institutions if a merger isn’t available or it would be too costly.

Briefly explain the purchase and assumption method of terminating DI

The purchase and assumption or the merger of a failed FI with a healthy FI. The healthy bank assumes the assured and uninsured deposits of the failed bank. This is the most common approach used.

What is the open-assistance method?

A method used for very large banks, because when they fail, it’s hard to find other banks big enough to engage in a merger. In this case the CDIC loans funs to keep the bank open.

What are global systemically important financial institutions

This accounts for banks that are too big to fail in which failure would cause significant systemic risk to the market.

What is the insured deposit transfer method?

This method encourages depositor vigilance because insured deposits of a bank are transferred in full to another local bank. Insured deposits never loose but uninsured depositors are subject to a cut to original claims.