Testing the safety net in banking: Is deposit insurance adequate?

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Recent events in the banking industry in Kenya have caused the Central Bank of Kenya (CBK) and other financial regulatory bodies to pause and rethink the current approach towards the regulation of the banking sector. Presently, the main issues facing Kenya’s banking industry are excessive insider lending, non-performing loans, inadequate or non-existent credit documentation and securities, liquidity problems and the poor management of banks (and other financial institutions). These issues have in some cases proved to be sure recipes for highly-publicized scandals or the downright collapse of the financial institutions involved.

Of utmost concern obviously is the impact that the collapse of several financial institutions has had on their depositors, bondholders, creditors and customers. Serious questions have been raised regarding the adequacy of the measures put in place for the protection of their deposits in the form of deposit insurance or otherwise. Indeed, anyone affected by the failure or collapse of a bank or financial institution should take a keen interest in the role that deposit insurance plays in such a situation.

Deposit insurance is a mechanism that has evolved over time to provide protection to depositors of commercial banks or deposit-taking entities, in the event of failure of the institution. It is also intended to play a critical role in contributing to the stability of the financial system of a country and in fostering economic development while encouraging savings.

The Deposit Insurance Fund

Kenya has in place the Deposit Insurance Fund (the Fund) which provides insurance protection to depositors against potential loss of their deposits in the event of failure of a member financial institution. The Fund is managed by the Kenya Deposit Insurance Corporation (KDIC), which was established under the Kenya Deposit Insurance Act, 2012 (the Act). Membership is compulsory for all institutions licensed to carry on deposit taking business such as commercial banks, financial institutions, mortgage finance companies,building societies and micro finance institutions.

The Banking Act (Cap. 488) also empowers CBK to intervene in the management of a bank or other financial institution by among other things, appointing KDIC to administer or liquidate any institution if it is established that its assets are less than its liabilities to its creditors.

KDIC is both publicly and privately funded. It is autonomous in its operations and not subject to the control, direction or supervision of any other entity in the exercise of its rights, powers, and privileges. However, any party aggrieved by the exercise of those powers may apply to the High Court for appropriate orders.

Degree of Protection

As stated above, one of the functions of KDIC is to provide and manage a deposit insurance scheme for depositors. However, the degree of protection provided to depositors and customers of collapsed financial institutions in Kenya is fairly low in comparison to that provided by other countries. KDIC offers limited coverage for deposits placed with an institution up to KES 100,000 (approximately USD 1,000) or such higher amount, as it may from time to time determine.

Furthermore, the Act provides that where a depositor owns more than onedeposit account with an institution, the aggregate of those deposits is insured up to only KES 100,000 – hardly an incentive to keep a large deposit or have more than one deposit account in the same institution. Nonetheless, in recent months CBK has allowed depositors to withdraw up to KES 1 million (approximately USD 10,000) in situations where a bank or financial institution is placed under receivership. This has been a great relief to small depositors but it is disadvantageous to large ones whose deposits far exceed the maximum amount that can be claimed.

The deposit insurance scheme in other countries such as the United Kingdom and the United States of America is relatively advanced in terms of funding and coverage. For instance, in the US the Federal Deposit Insurance Corporation covers up to USD 250,000 (KES 25 million) depending on the type of account one holds with an institution. This amount is quite generous and lends credibility to the ultimate objective of deposit insurance. In the UK, quite apart from insuring deposits, the Financial Services Compensation Scheme extends the protection offered to insurance policies and insurance brokers. Furthermore, deposits are covered up to a maximum of GBP 75,000 (approximately USD 100,000)(KES 10 million). Naturally, this kind of protection comes at a price as it is commensurate to the high premiums levied on member institutions.

Interestingly, it has been argued that the deposit insurance system in the UK is unduly expensive and that it unfairly subsidizes poorly managed banks. It has also been argued that deposit insurance undermines market discipline. The rationale being that as a result of having such an insurance scheme in place, financial institutions tend to take undue risks while customers take little or no interest in the way these institutions are being run.

In Kenya, despite the relatively low level of protection offered, unscrupulous financial institutions do not seem to shy away from taking very high (and in certain cases illegal) risks with depositors’ funds. Such unrestrained risktaking, coupled with depositors’ disinterest, ignorance or blind trust in financial institutions ultimately leads to their imminent failure or collapse.

Ideally, deposit insurance should reduce the risk of a bank run based on the premise that depositors who are assured that the insurer will reimburse their deposits in the event of a bank failure, are less inclined to withdraw their deposits in the event of an institution’s insolvency.

Need for Reforms

While the country is experiencing a number of long-awaited reforms in the banking sector, more focus should be directed towards the reform of the existing deposit insurance legislation. The current approach to banking in Kenya is reactionary as opposed to pre-emptive, with protective measures being adopted after the event of a collapse, failure or liquidation of a financial institution, often being a case of too little, too late. In the absence of a significant increase in deposit insurance coverage which is aligned with the current inflation rate, it is doubtful whether the objectives of the scheme will ever be achieved.

The Act provides that premiums are limited to a maximum of 0.4 per cent of the average of a members total deposit liabilities in a twelve (12) month period prior to assessment. This percentage needs to be adjusted upwards for the deposit insurance to be of any relevance and coverage of deposits should also be increased, so as to be in tune with changing economic times.

Such reforms will serve the country better in terms of enabling KDIC to fulfill its deposit insurance mandate, as well as enhancing confidence and, in turn, stability in the financial system. Indeed, President Franklin D. Roosevelt aptly remarked while exhorting citizens to remain calm and avoid making the panicked withdrawals, which had crippled America’s banking system in 1933: “After all, there is an element in the readjustment of our financial system more important than currency, more important than gold, and that is the confidence of the people.”