Optimal Pricing of Deposit Insurance: Aiming at Fairness and Stability

Abstract

Deposit insurance has two main objectives: at the micro-level, it should protect small depositors against the failure of their bank and at the macro-level, it should contribute to the stability of the financial system and of the economy as a whole. To have the appropriate resources to achieve their mission, deposit insurers collect premiums from insured banks to build a so-called ex-ante fund. Setting an optimal pricing scheme is a challenge. On one hand, it should be fair, that is correctly adjusting for the risk of each bank and on the other hand it should be consistent with the stability objective, which implies avoiding pro-cyclicality. Up to now, two main pricing schemes have been used: fixed rate pricing and risk adjusted rate pricing. Our analysis shows that none achieves both goals satisfactorily. Fixed rate pricing is not pro-cyclical but it is somewhat unfair as it does not adjust for risk. Risk adjusted rates are fair but are pro-cyclical. This paper proposes a new approach based on relative risk that reconciles both objectives. Relative risk is defined as the difference between the risk measure of a bank and the weighted risk measure of the banking sector. A numerical example illustrates the working of the new approach and shows that it adjusts for risk and avoids pro-cyclicality while allowing the deposit insurer to accumulate the same revenues over the cycle. Finally, the materiality of the problem of pro-cyclicality and the performance in terms of effectiveness and efficiency of the proposed model are discussed.