Bank regulation seeks to ensure the proper functioning of the financial system. Confidence in and stability of this system is required to keep the economy afloat. From its core and traditional function, banks act as a financial intermediary between savers and borrowers of capital. As such banks have continuing obligations towards depositors and bear the credit risk of their borrowers. Savers therewith experience an indirect risk when borrowers are unable to honor their obligations to the bank. Thus, bank insolvency due to borrowers default places savers at risk for their deposit or investment above deposit insurance limits.
In a free market economy, economic growth is advanced by liquidity provision. This means that borrowers can use financial forecasts as collateral for credit facilities. Financial institutions must therefore attract sufficient capital to meet the demand side of the market. Funding of financial institutions is a combination of techniques of which the most common are fractional reserve lending and the securitization and sale of loan packages. In a perfect market illicit behavior and excessive risk taking is non-existent whilst borrowers do not default on their loans. Reality, however, reveals detrimental conduct and default ratios where bank risk modelling does not always have the answer for. As a consequence, global bank regulation requires financial institutions to hold capital adequacy ratios for possible loss absorption.
The biggest misconception in finance is that banks and other financial institutions hold sufficient liquidity to repay all creditors on demand. Financial institutions are not liquid. The value of their assets fluctuate and its share value is subject to market conditions and perceived worth by investors. When banks get into trouble, investors sell their shares and speculation on devaluation and short selling gains altitude. Combined with a run on the bank by regular depositors creates a perfect storm to bankrupt the bank. Regulators therefore intervene before it is too late and bank depositors and other unsecured creditors lose their investment.
Deposit insurance as a tool for risk management
Global banking and finance is a complex field of business. It requires a multi sided approach towards risk management. The role financial institutions play in society justifies enhanced scrutiny. However, the free market economy needs liquidity to fuel consumption and economic growth. Therefore, the market should correct itself. This is possible on a ceteris paribus level that is further complicated by a mismatch between the consumer understanding and desire and the ownership of risk taking.
Deposit insurance has several objectives. Its eligibility seeks to address all these objectives. Therefore, the term ‘deposit guarantee scheme’ is not always applicable because the objective of deposit insurance do not always match with the designated creditor claim. The general objectives of deposit insurance are:
- To maintain confidence in the financial system by providing bank depositors with a maximized protection of their account balance.
- To restrict excessive risk taking by financial institutions by maximizing the insured amount.
- Following the open market economy, to let the bank customers and other creditors punish wrongdoers and exorbitant risk taking by taking their money elsewhere and launch civil claims to cover damages.
- To avoid unfair or double protection for creditors that are covered under different schemes as well.
Is deposit insurance guaranteed, or not?
Deposit insurance applies to qualifying accounts. To qualify, the four general objectives must be met whilst premiums over the account are paid by the bank to the DGS administration. In general, public authorities, holding companies and financial institutions seldom qualify for deposit insurance. This is mainly caused by to their function in society and the possibilities they have for external and additional recourse. For example, a financial trader may secure his investment via a swap contract or by arbitrage. Deposit protection would then provide for an unfair advantage which should not be allowed. To conclude, deposit insurance is guaranteed for qualifying bank depositors who submit a valid proof of debt and proof of claim. This is to ensure that the correct beneficiary receives the deposit insurance payment.