Discussion of

1
Discussion of Options for Addressing Moral
Hazard and Transitioning from Blanket Deposit
Guarantees to Effective Limited-Coverage Deposit
Insurance
by George Pennacchi Department of
Finance University of Illinois
2

• Both papers present many sensible guidelines for
  developing a
• sound and limited system of deposit insurance.

• An issue that deserves more emphasis is how
  moral hazard and
• the safety net might be contained by
  restricting a banks financial
• structure and its assets and activities.

• Private credit agreements and guarantees place
  restrictions
• (covenants) on the borrowers use of funds.
  Similarly,
• deposit insurers should limit the activities
  that can be funded
• with insured deposits.

• Properly implemented, such limitations can lead
  to less intrusive
• and more efficient regulation of a banks
  overall activities, while
• lessening moral hazard and the insurers
  exposure to loss.

3

• Financial innovation has greatly expanded the
  number of
• financial contracts and securities offered by
  banks, many of
• which are risky, hard to value, and difficult
  to monitor.

• While this phenomenon is most apparent in
  developed countries,
• many developing country bank assets and
  activities also are
• hard to value and monitor by bank supervisors.

• Similar to the practice of requiring good
  collateral in private
• credit contracts, backing insured deposits with
  relatively
• transparent bank assets can simplify
  supervision by regulators.

• Moreover, risk-based pricing of deposit
  insurance would be less
• complex and arbitrary.

4

• Limitations can take many forms, depending on
  the state of a
• countrys financial development
• 1) In countries with universal banks, issuing
  insured deposits could
• require that banks pledge core banking
  assets or high-grade
• money market instruments. (c.f., depositor
  preference.)
• 2) In countries where bank activities are
  segregated in a holding
• company, only subsidiaries restricted to
  core banking assets or
• transparent money market instruments could
  issue insured deposits.
• (Capital and/or subordinated debt would also
  be required.)

• Essentially, these restrictions go beyond
  depositor preference and
• senior/subordinated structures to link insured
  deposits with
• relatively transparent assets. Banks would be
  free to finance
• relatively opaque and risky activities with
  uninsured liabilities.

5

• A greater demand for insured deposits would
  generate more supply
• of transparent assets lower interest rates on
  transparent loans and
• money market debt induce firms to issue more of
  such liabilities.

• Governments can also augment the supply of
  transparent assets.
• Developing a market for Treasury bills creates
  a riskless security
• that is an alternative to insured deposits
  backed by opaque assets.
• T-bills can be held by banks to back insured
  deposits or held
• directly by those investors demanding safety.
  (c.f., savings bonds.)

• Arrangements that tie insured deposits to
  relatively transparent,
• safe assets and uninsured bank liabilities to
  more opaque, riskier
• assets allow investors to self-select by their
  willingness and ability
• to monitor banks. A banks cost of funding
  risky, opaque activities
• would better reflect investors cost of
  monitoring a bank that
• chooses such activities. Moral hazard would be
  contained.

6

• Are there sufficient numbers of sophisticated
  investors to provide
• (uninsured) financing of opaque bank
  activities?

• If past policy was to provide blanket deposit
  insurance guarantees,
• currently the number of informed investors may
  be low. However,
• credit information, investor sophistication,
  and the level of
• monitoring are endogenous, responding to a
  perceived need.

• This observation supports the papers
  recommendation that a
• government should commit to a gradual increase
  in market
• discipline and a gradual limitation of deposit
  insurance coverage.

• If such a commitment is credible, private
  institutions and
• mechanisms for gathering and analyzing credit
  information (e.g.,
• rating agencies, credit history databases,
  credit scoring technology,
• enhanced accounting information) will expand.

7

• Ultimately, if insured deposits can be fully
  collateralized with
• relatively transparent assets, setting
  risk-based deposit insurance
• premiums will be easy the value of insurance
  will be close to zero.

• Prior to reaching this point, one should avoid
  setting deposit
• insurance premiums to target the level of
  reserves in a deposit
• insurance trust fund. The level of fund
  reserves reflect past losses,
• not future losses, incurred by the deposit
  insurer.

• If deposit insurance is to be priced fairly (not
  provide a subsidy to
• banks relative to similar intermediaries cost
  of financing), it must
• reflect a banks risk of imposing future claims
  on the deposit insurer.

• This is how private insurance contracts would be
  priced. Indeed,
• the scope for partially replacing government
  with private deposit
• insurance should be investigated.