Finland has a very sound financial system. Finland is at the forefront of electronic banking and financial sector consolidation. Arrangements for crisis prevention and management need to balance the conflicting goals of minimizing moral hazard and providing adequate safety nets in the financial system. There are some deficiencies as regards compliance with certain of the banking supervision and securities standards. In view of the advanced stage of development of Finland's financial system, supervisory arrangements will need to meet and even exceed international standards.
This paper demonstrates a well-designed deposit guarantee system can strengthen incentives for owners, managers, depositors and other creditors, borrowers, regulators and supervisors, and politicians. Borrowers should be aware that they will have to repay their loans if their bank fails and will be encouraged to keep their loans current where offsetting is limited to past-due loans. The performance of insurers, regulators, and supervisors as agents will improve where they know that they can take justifiable actions without political interference and will be held accountable for their actions to their principals. Despite the improvements, and possibly partly because there are issues in deposit insurance design that remain to be resolved, financial crises have been prevalent during the 1990s. This situation has forced a number of countries to offer a blanket guarantee to restore confidence and to allow the continued functioning of the financial system while the authorities take time to design a plan for the resolution of the crisis.
In most countries, banks are the most important financial institutions for intermediating between savers and borrowers, assessing risks, executing monetary policy, and providing payment services. At the same time, the configuration of their portfolios makes them especially vulnerable to illiquidity and insolvency. In particular, by law, bank deposits have to be repaid at par: in addition, banks are highly leveraged and often maintain liquid assets to meet withdrawals only in normal times. In light of this vulnerability, government officials realize that the demise of one bank, if handled poorly, can spill over to others, creating negative externalities and causing a more general problem for other banks in the system. For these reasons, many governments provide a safety net for banks that generally includes deposit protection and lender-of-last-resort facilities, in addition to a system of bank regulation and supervision. Recognizing that financial stability is a public-good with regional, and even global, implications (see Wyplosz, 1999), the international community is showing an interest in deposit protection.
The proliferation of banking and financial crises during the 1980s and 1990s has led a large number of countries to institute, or consider instituting, an explicit system of deposit insurance (see, for example, Lindgren, Garcia, and Saal, 1996).2 In fact, 30 of the 72 countries now known to have an explicit deposit insurance system established it during the past decade; 49 set up their systems in the past 20 years. During the 1990s, 33 countries reformed their deposit insurance systems, often to improve its incentive structure in light of experience.3
A recent survey of 85 different systems of deposit protection found that of the 85, 67 countries offered an explicit, limited deposit insurance system in normal times (see Table A1 of the Statistical Appendix).46 They are the focus of the survey that follows.47 As Table 2 shows, four of the surveyed countries are in Africa, 10 are in Asia, 32 are in Europe, four are in the Middle East, and 17 are in the Americas.
While a well-designed, limited system of deposit insurance can protect small depositors’ funds in normal times, help to avoid unjustified runs, and provide a framework for the efficient resolution of individual failed banks—thus enhancing systemic stability—a limited system cannot be expected to maintain systemic stability in the face of an unforeseen shock of massive proportions or where weaknesses have been allowed to become so widespread that the system shudders even in response to smaller shocks. Faced with such a scenario and recognizing that financial stability is a public good, the government may decide to take emergency action to preserve the stability of the financial sector. It may also choose to bear the costs of the economic emergency and override the system of limited deposit protection and offer a full, temporary guarantee of depositors and creditors to ensure the continued functioning of the financial system. That guarantee should, however, be removed as soon as possible and replaced by a formal, limited, compulsory system of deposit protection that is funded by the banking system and supported by a good incentive structure, including effective regulation and supervision.
Banks are vulnerable to illiquidity and insolvency. Because of banks’ importance to the economy, most governments have chosen to implement a financial safety net to deal with such contingencies. A system of depositor protection that guards the holders of small deposits when their bank fails has in recent years become part of this safety net in a growing number of countries. A well-designed system of deposit insurance can strengthen incentives for good governance for banks (via strong internal governance from owners and managers, firm discipline from the markets, and effective bank supervision bank regulation).