Financial Update (January-March 1996)

Deposit Insurance Requires Aggressive Bank Supervision, Economist Says

An aggressive mechanism for examining and supervising banking activities is crucial for any organization providing deposit insurance, Mark Flannery, an economics professor at the University of Florida, told a group of primarily East European bankers.

That advice was among the guidance Flannery gave East European financial ministers, central bankers, and deposit insurance agency representatives at a December conference offered by the Institute for East-West Studies and the Federal Reserve Bank of Atlanta.

Eastern Europeans' interest in deposit insurance is rooted in their desire to promote financial stability and to protect the small depositor. Accomplishing these goals, in turn, should encourage savings, investment, and economic growth. The leaders of these nations also know that governments often are expected to resolve financial crises, which can be expensive and take their toll on the economy. Therefore, they are seeking to create a system that makes crises less likely. Finally, many of these countries wish to join the European Union, and having a deposit insurance system is among the criteria.

Flannery traced out two paths they might follow to achieve their goal. One approach is market discipline. In essence, when creditors learn that a bank is having trouble, they will demand a higher premium for keeping deposits at such a bank. But creditors will be willing to take this risk only if they believe that the bank has the incentive to improve and resolve its problems and that the creditors will receive the higher interest.

However, such market discipline must be feasible, he pointed out, meaning that accounting systems, records, and internal controls—and even bankruptcy laws—must be in place. Also, countries must have enough large creditors—corporations, governments, or money managers—who can diversify their respective investments. Small depositors are not usually in a position to take such risks, Flannery said.

Another approach is for the government to step in and guarantee the deposits. The advantage is that the financial institutions will not experience bank runs and capital flight will be less likely. But the disadvantage is that private organizations then lack the incentive to oversee risk. As a result, the government has to step in with aggressive regulation and supervision. That action typically requires higher capital, he said, and also profit caps as well as a floor on losses since higher returns are associated with higher risk.

Flannery suggested that the East European financial leaders assembled should consider which option—or combination of the two—would work best in their nations.

On balance, Flannery told the East European policymakers that safety nets in the financial system are useful, especially in countries where capital markets are less developed. But it is important to design good incentives to minimize the likelihood of the disasters for which the safety net is intended. In addition, it is wise, in his view, to try to phase out such systems over time. Deposit insurance systems should also minimize the central bank's ability to lend to insolvent institutions.

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