WWW.WORLDBANK.ORG/FINSAC Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized DEPOSIT INSURANCE SYSTEMS: ADDRESSING EMERGING CHALLENGES IN FUNDING, INVESTMENT, Public Disclosure Authorized RISK-BASED CONTRIBUTIONS & STRESS TESTING Edited by Jan P. Nolte & Isfandyar Z. Khan November 2017 Contents Introduction . 3 Determining the Target Deposit Insurance Fund: Practical Approaches for Data-Poor Deposit Insurers . 5 Risk-based Premium Models for Deposit Insurance Systems . 45 Investing for the Bad Times: How to Achieve a Balanced Investment Strategy for a Deposit Insurance Fund . .. 85 Deposit Guarantee Scheme Contingency Planning and Stress Testing . 134 Authors . 165 © 2017 International Bank for Reconstruction and Development / International Development Association or The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the external consultants with contributions by staff of The World Bank. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522- 2625; e-mail: [email protected] INTRODUCTION A well functioning financial sector safety net is an essential elemement for a financial sector. It guarantees the safety of the banking system and its deposits, inspires confidence in the system and safeguards against any shocks. The global financial crisis of 2008/9 highlighted, among other things, the need for countries to strengthen one pillar of this safety net, their deposit insurance frameworks1, to ensure a high degree of depositor confidence in the financial system. As a direct response to the crisis, IADI (the International Association of Deposit Insurers2) published first jointly with the Basel Committee for Banking Supervision in 2009 the Core Principles for Effective Deposit Insurance Systems. The Core Principles (updated in 2014) cover a wide range of issues - including mandate and powers, funding, payout capacity and contingency planning as well as crisis management of the DIS and its staff. The Core Principles stipulate a minimum standard against which deposit insurance schemes around the world benchmark themselves. Since its publication, the Core Principles have supported many deposit insurance related reforms around the world and have been instrumental in setting up new schemes. In the European Union, the Deposit Guarantee Scheme Directive which was first effected in 1994 underwent a thorough reform process after the crisis. It was replaced with the introduction of a ‘maximum harmonization’ Directive on Deposit Gurantee Schemes (2014/49/EU) to be followed in all Member States. The Directive added increased protection for depositors, a minimum target level for the deposit insurance funds, risk-based premiums, investment rules for the deposit insurance fund as well as a requirement for stress testing. The Directive is in the process of being fully implemented in the EU. But its reach goes beyond its Member States as other countries in the wider region use the Directive as a guiding principle for their own frameworks. The Financial Sector Advisory Center (FinSAC) has responded to the need for deposit insurance reform and engages with various stakeholders to strengthen deposit insurance schemes in its client countries. Based in Vienna, FinSAC is a dedicated technical unit of the World Bank’s Finance & Markets Global Practice that aims to deliver policy and technical advice and analytical services to client countries in the Emerging Europe and Central Asia (ECA) region3. Until today, it has sponsored technical assistance for deposit insurance projects in countries such as Bosnia and Herzegovina, Bulgaria, Croatia, Montenegro, Romania and Serbia. 1 Deposit insurance is a system established to protect depositors against the loss of their insured deposits in the event that a bank is unable to meet its obligations. 2 www.iadi.org 3 FinSAC was established in June 2011 through joint collaboration of the Austrian Ministry of Finance and the World Bank’s Private and Financial Sector Department. A Trust Fund Agreement, financed by the Austrian Government, was signed between the parties and FinSAC opened its offices in September 2011 with the creation of a Technical Advisory Center in Vienna. 3 The four guidance papers of this FinSAC publication are dealing with topics which have been identified during the technical assistance projects as important, current issues for deposit insurance practitioners where further guidance is needed. The topics are of interest for all types of deposit insurance systems irrespective of its mandate4. They deal with aspects of funding (the ability of the deposit insurer to calculate its financial needs), investment (the challenge of the deposit insurer to find safe and highly liquid investments in the current investment climate), risk-based contribution (how to develop a model which takes into account the individual risk of banks) and, finally, how to perform stress testing of a system (to be better prepared for future crisis and ensure rapid response to different scenarios). We hope that deposit insurers as well as other members of the financial safety-net such as central banks and supervisors will find this publication helpful for their work. 4 Typical mandates can be broadly classified into four categories: Pay Box; Pay Box Plus; Loss Minimizer; and Risk Minimizer. 4 Determining the Target Deposit Insurance Fund: Practical Approaches for Data-Poor Deposit Insurers DETERMINING THE TARGET DEPOSIT INSURANCE FUND: PRACTICAL APPROACHES FOR DATA-POOR DEPOSIT INSURERS John P. O’Keefe & Alexander B. Ufier Determining the Target Deposit Insurance Fund: Practical Approaches for Data-Poor Deposit Insurers Contents 1 . Introduction . 8 1.1. Deposit Insurance Funding ............................................9 1.2. Determining the Target Deposit Insurance Fund ..........................10 2 . Proposed Target Fund Framework . .. 12 2.1. Identifying States of the World .......................................12 2.1.1. Constructing Principal Components ...............................13 2.1.2. Identifying Crisis Periods .......................................14 2.1.3. Calibrating to Other Periods ....................................15 3 . Probability of Bank Failure . 16 3.1. Types of Failures in Simulation Study ...................................16 3.1.1. Credit Failures ................................................16 3.1.2. Monte Carlo Simulations of Credit Failures .........................17 3.1.3. Liquidity Failures ..............................................18 3.1.4. Systemic Failures .............................................19 3.2. Estimating Probabilities of Failure ......................................20 3.2.1. Statistical Models of Bank Failure .................................20 3.2.2. Rating Agency-based Forecasts of Bank Failure ......................22 3.2.3. Actuarial Bank Failure Rates .....................................24 4 . Loss Given Default . 25 4.1. Failure Resolutions .................................................25 4.1.1. Priority of Claimants ...........................................25 4.1.2. Structure of Losses ............................................26 4.2. Deposit Insurance Losses ............................................26 4.3. FDIC Loss Rates ...................................................27 5 . Exposure at Default . 28 5.1. The U.S. Case .....................................................28 6 . Correlation of Bank Failures . 29 6.1. Stock Return Data ..................................................29 6.2. Book Equity .......................................................30 7 . Model Calibration . .. 30 7.1. Probability of Default ...............................................30 7.1.1. Statistical predictions ..........................................30 7.1.2. Issuer Default Ratings ..........................................30 7.1.3. Industry Failure Rates ..........................................31 7.2. Loss Given Default .................................................31 7.3. Exposure at Default .................................................31 7.4. Correlation of Default ...............................................31 6 Determining the Target Deposit Insurance Fund: Practical Approaches for Data-Poor Deposit Insurers 8 . Model Results . 32 8.1. Desired Fund Size ..................................................32 8.2. Longer Horizons ...................................................34 9 . Inherent Weaknesses of Model Assumptions . 34 10 . Conclusion . 35 Acknowledgements ....................................................36