Fair Premium Rate of the Deposit Insurance System based on Banks’ Creditworthiness

Abstract

Purpose: Deposit insurance is a key element in modern banking, as it guarantees the financial safety of deposits at depository financial institutions. It is necessary to have at least a dual fair premium rate system based on the creditworthiness of financial institutions, as considering a singular premium system for all banks will have a moral hazard. In this paper, we develop a theoretical as well as an empirical model for calculating dual fair premium rates. Design/methodology/approach: Our definition of a fair premium rate in this paper is a rate that can cover the operational expenditures of the deposit insuring organization, provides it with sufficient funds to enable it to pay a certain percentage share of deposit amounts to depositors in the case of bank default, and provides it with sufficient funds as precautionary reserves. To identify and classify healthier and more stable banks, we use credit rating methods that employ two major dimensional reduction techniques. For forecasting nonperforming loans (NPLs), we develop a model that can capture both macro shocks and idiosyncratic shocks to financial institutions in a vector error correction model (VECM). Findings: The response of NPLs/loans to macro shocks and idiosyncratic innovations shows that using a model with macro variables only is insufficient, as it is possible that under favorable economic conditions some banks perform negatively for bank-level reasons such as mismanagement, or vice versa. Final results show that deposit insurance premium rates need to vary in relation to banks’ creditworthiness. Value: The results provide interesting insight for financial authorities to assist them in setting fair deposit insurance premium rates. A high premium rate reduces the capital adequacy of individual financial institutions, which endangers the stability of the financial system; a low premium rate reduces the security of the financial system.