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Chapter 19 Deposit Insurance and Other Liability Guarantees.docx

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FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 19 Deposit Insurance and Other Liability Guarantees INTRODUCTION  Contagious run or panic conditions, liability holders do not bother to distinguish between good or bad FIs but seek to turn liabilities into cash o Contagious runs can have major contractionary effect on supply of credit and money supply regionally, nationally, or internationally, as well as serious social welfare effects The Canadian Experience with Deposit Insurance  Canadian Deposit Insurance Corporation (CDIC) support for deposits of federally regulated deposit-taking institutions with risk minimization and early intervention policies o Under the Bank of Canada Act and Canadian Payment Act, members of CDIC are eligible to operate in Large Value Transfer System and to borrow from Bank of Canada  Office of the Superintendent of Financial Institutions (OSFI) was created to supervise federally regulated trusts, insurance companies, and banks  Bank of Canada does not directly supervise and audit federally regulated FIs but it does have mandate to ensure safety and soundness of financial system, and therefore its monetary policy affects both OSFI and CDIC  Regulatory forbearance – regulators’ policy of allowing an FI to continue to operate even when it is in breach of regulations in hopes that the situation will correct itself over time CAUSES OF DEPOSIT INSURANCE INSOLVENCY The Financial Environment  Insolvency is caused from a number of external events or shocks that can adversely affect DTIs (i.e. rise in interest rates in 1979-1982; collapse of oil, real estate, and other commodity prices,; increase financial service firm competition at home and abroad; housing bubble burst in 2007)  As economic conditions decline, overleveraged consumers and businesses default on their loans Moral Hazard  Financial environment effects were catalysts for, rather than the cause of, economic crises  Moral hazard – loss exposure faced by an insurer when provision of insurance encourages the insured to take more risks o Deposit insurance allowed insured FIs to borrow at rates close to the risk-free rate, and to undertake high-risk asset investments  In the absence of depositor discipline, regulators could have priced risk-taking either through charging explicit deposit insurance premiums linked to the FI’s risk taking or by charging implicit premiums through restricting and monitoring the risky activity of FIs o Implicit premiums – deposit insurance premiums or costs imposed on DTI through activity constraints rather than direct monetary charges PANIC PREVENTION VERSUS MORAL HAZARD  Difference between DTIs and other firms is risk-taking incentives induced by mispriced deposit insurance  Actuarially fairly priced insurance – insurance pricing based on the perceived risk of the insured  By restructuring deposit insurance contract, possible to reduce moral hazard risk without a large increase in run risk o Full coverage of all depositors and reducing probability of runs to zero means insurer may be encouraging certain DTIs to take significant degree of moral hazard risk-taking behaviour o Limited degree of insurance coverage might encourage runs and panics, although moral hazard behaviour would be less evident CONTROLLING RISK-TAKING  Three ways deposit insurance could be structured to reduce moral hazard behaviour 1. Increase stockholder discipline – insurance premiums, increased capital requirements 2. Increase depositor discipline – insured depositor, uninsured depositor 3. Increase regulator discipline – examinations, regulatory forbearance Stockholder Discipline  Insurance premiums are linked to risk profile of DTIs; if premiums increased as bank risk increased, banks would have reduced incentives to take risks FIN701 Financial Institutions Management o Ultimate goal is to price risk in an actuarially fair fashion so that premiums reflect expected private costs or losses to insurer from provision of deposit insurance  Option pricing model of deposit insurance (OPM) – model for calculating deposit insurance as a put option on DTI’s assets o Risk-based deposit insurance program – program that assesses insurance premiums on the basis of capital adequacy and supervisory judgements on FI quality  Based score out of 100, FI placed into one of four categories where incentive is to maintain high score so that the cost to the FI is minimized, since insurance premium for dep
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