Deposit Insurance in Chile

My route to this paper is, perhaps, best described at another time. But Deposit Insurance: Handle with Care is a good background paper with excellent references.

The abstract:

Explicit deposit insurance has been spreading rapidly in the past decades, most recently to countries with low levels of financial and institutional development. This paper documents the extent of crosscountry differences in deposit-insurance design and reviews empirical evidence on how particular design features affect private market discipline, banking stability, financial development, and the effectiveness of crisis resolution. This evidence challenges the wisdom of encouraging countries to adopt explicit deposit insurance without first stopping to assess and remedy weaknesses in their informational and supervisory environments. The paper also includes recommendations for reforming the Chilean deposit insurance system based on the results of the research reviewed here.

… and a few observations …

On investigating individual design features, Demirgüç-Kunt and Detragiache also show that deposit insurance causes the most trouble in countries where coverage is extensive, where authorities amass a large fund of explicit reserves and earmark it for insolvency resolution, and where the scheme is administered by government officials rather than the private sector.

It is common practice to issue blanket guarantees to arrest a banking crisis. Countries that have adopted this strategy include Sweden (1992), Japan (1996), Thailand (1997), Korea (1997), Malaysia (1998), and Indonesia (1998). More recently, Turkey tried to halt its financial panic by guaranteeing not just bank depositors, but all domestic and foreign nondeposit creditors of Turkish banks. Advocates of using blanket guarantees to halt a systemic crisis argue that sweeping guarantees can be helpful, even essential, in halting depositors’ flight to quality. However, because blanket guarantees create an expectation of their future use in similar circumstances, they undermine market discipline and may prove greatly destabilizing over longer periods. Although some countries have managed to scale back formal insurance coverage once a crisis has receded, it is very difficult to scale back informal coverage in a credible manner.

Concentrated banking systems experience fewer systemic banking crises (Beck, Demirgüç-Kunt, and Levine, 2003) and almost always generate a high level of implicit insurance coverage, partly because of “too big to fail” pressures. Not surprisingly, empirical evidence confirms that incremental exposure to moral hazard from introducing an explicit insurance system is limited in highly concentrated environments.

By the way …

Deposit insurance was established in Chile in 1986. The system does not have a permanent fund in place. The Chilean Central Bank guarantees 100 percent of demand deposits in full, and 90 percent of household savings and time deposits up to UF 120 per person (approximately US$ 2,800). To limit the Central Bank’s exposure, banks with demand deposits in excess of 2.5 times the capital reserves are required to maintain 100 percent reserves at the Central Bank in short-term central bank or government securities. Foreign exchange deposits are covered, but coverage excludes interbank deposits. Membership is compulsory for all banks, and the scheme is publicly administered.

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