Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
Procyclicality of the New Basel Accord and Deposit Insurance The Korea Case
Dong Han Chang*
From the beginning of 2008, the new Basel Capital Accord (Basel II) has been implemented in
Korea, which would have several macroeconomic implications to banking industry as well as
Korean economy as a whole. Basel II and deposit insurance are closely related each other
since a rationale of strengthening capital regulation and risk management for banks is for moral
hazard problem of deposit insurance system. Therefore, it is important to analyze the effects of
Basel II on deposit insurance system and seek better ways to improve current system. This
paper reviews the procyclical impact of Basel II and proposes a deposit insurance premium
design that can reduce the procyclicality problem. Specifically we suggest aggregate premium
policy that is countercyclical in nature and can neutralize procyclical effect of Basel II. The basic
idea is to relieve aggregate premium in bad times and raise it in good times. By allocating the
burden of aggregate premium to each bank based on its own risk, this deposit insurance
system could be fair enough with differentiated rating scheme while being able to reduce
procyclicality of Basel II.
Field of Research: Finance
I. Introduction
Since January of 2008, the new Basel Accord has been implemented in Korea. The Basel
committee on banking supervision of BIS(Bank for International Settlements) implemented
Basel II to improve problems that Basel I had. Bank‟s risk management strategies will be
changed and there will be a great amount of effects on the banking industry as well as overall
economy.
The main point of Basel II is „strengthening risk management.‟ This can be divided into three
pillars. In other words, when it comes to managing bank‟s minimum capital requirements, it is
properly reflecting risk differences (pillar 1), the authorities are thoroughly monitoring credit ·
_________________________________________________________________________________________
*Professor, Department of International Trade, KonKuk University, Seoul, KOREA, dhchang@konkuk.ac.kr, 822-450-3650(Tel), 82-2-3437-6610(Fax)
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
market • management risks as well as interest rate • liquidity• strategy management risks
(pillar 2) and the intensified public disclosure and transparency (pillar 3). These attempts
promote bank‟s potential risk management abilities and strengthen direct or indirect outside
monitoring. Strengthening risk management is ultimately pursuing protection of financial
customers and stability of financial systems.
Strengthening bank‟s capital regulations and risk management systems has an aspect of
alleviating moral hazard problem which was originally undertaken in a deposit insurance
system. In this point, Basel II and deposit insurance are closely related each other. Thus,
analyzing the effects what Basel II affect deposit insurance and devising proper schemes
have an important meaning. The authorities should make Basel II protect financial customers
and increase stability of financial systems. To achieve these goals, the authorities should
improve policies and provide corresponding devices with potential unstable factors.
Among related issues, this study focuses on procyclicality of Basel II. According to Basel II,
when economic condition becomes aggravated (or the time that credit risk becomes larger in
overall economy), bank needs to save a lot more capital and this leads aggravated economic
conditions due to the loan diminution. As Basel II achieves its own aim, strengthening risk
management, procyclicality can be larger because of the side effects. This is a problem as
itself; however it can be aggravated if deposit insurance is run without concerning this
problem. Especially Korea is preparing the planned fund policy and the differentiated
insurance fee rate policy to better current deposit insurance policies. Among these policies,
the differentiated insurance fee rate policy is procyclical as itself. Thus, there may be a
possibility that risks of financial organizations would increase(decrease) when economic
depression(prosperity) comes so that insurance fee rate can be increased(decreased), and
this weakens(strengthens) bank‟s loan possibility. In the traget fund policy‟s case, it is not
absolutely procyclical. The target fund policy is rather alleviating procyclicality when it
lessens additional burden of financial organizations after reaching at the target size. However
it cannot be free from procyclicality until it reaches at the expected level. Especially, when the
planned fund policy and the differentiated insurance fee rate policy are mutually practiced,
they can bear procyclicality at least until they reach at the planned fund. As you try to reduce
time to the planned fund, procyclicality will be intensified.
The purpose of this study is to examine procyclicality of Basel II and devise a solution for
this concern. Especially it goes over schemes that neutralize procyclicality of Basel II by
running the planned fund policy in a reversed condition of real economic environment. In
other words, when economic depression appears, this method relieves the bank industry‟s
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
deposit insurance fee and when economic prosperity comes, this method strengthens its
burden. Following this way, total bank industry‟s insurance fee is run in the reversed way of
real economic condition, however when each bank pays for total fee, it can be differentiated
by its risk. If this method works, it can achieve fair insurance imposition, which is a main
purpose of the differentiated insurance fee policy, as well as neutralizing effects of
procyclicality of Basel II. First of all, the next chapter will go through main issues of Basel II
and chapter III will deal with one of side effects, which is procyclicality of Basel II. Chapter IV
brings up with resolutions, which are facing with procyclicality of Basel II, and the last chapter
will summarize the main issues and think about current affairs.
II. Procyclicality of Basel II
Bank‟s loan as itself has a nature of procyclicality. There are several approaches related
with this procyclicality, as microeconomics approach for example, according to Rajan(1994),
bank‟s supervisors are likely to conceal procyclicality by supporting additional capital to
borrowers, who are hiding the fact that they do not have abilities to pay back, for his own
reputation. However economic prosperity affects bigger effects on supervisor‟s reputation
than economic depression does when problematic loan has revealed. Thus, when economic
prosperity comes, loan becomes extremely active, on the contrary, when economic
depression comes, loan tends to be strict. Procyclicality of both economic condition and loan
can be explained by macroeconomics approach for instance, when economic depression
appears, the value of securities declines so that the fact that scale of loan is decreasing is
obvious to explain.
In reality, economic growth rate and banks‟ loan are closely related. <Figure 1> and <Figure
2> show both real GDP growth rate and nominal loan growth rate for each the United States
and Korea. In the United States case, when economic depression appears, loan becomes
extremely dull without exceptions, especially in the early days of 1990s, when a number of
banks bankrupted and the world was in depression, loan had decreased.
< Figure 1> Relationship between Economic Growth and Banks’ Loan (US)
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
Source: Goodhart(2004), p.606, Figure 5.
<Figure 2> Relationship between Economic Growth and Banks’ Loan (Korea)
Source: The Bank of Korea.
According to <Figure 2>, Korean case has rather smaller correlation than America, however
economic growth and loan are closely related in overall. In the late days of 1990s in Korea, of
course, IMF crisis affected economic growth rate down to minus degree and financial
industry kept going on a big scale of lay-offs so that bank loan(in the standard of total amount
of loan of deposit bank) was extremely shrunk to show decreasing rates. On the other hand,
when carefully looking <Figure 1> and <Figure 2>, variations of economic growth rate of
Korea and the United States are both proceeding a little bit rather than variations of loan
growth rate. This has an important meaning as making policies. In other words, when taking
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
actions preemptively, there will be enough time to prevent dramatic loan shrinking, and
through this way, it can alleviate variations of loan to some degree. For instance, in Korean
case, as getting into 1999, economic conditions started being recovered so that economic
growth rate reached at 9.7% in the second quarter which led a mechanism, which is
suppressing extreme loan expansion, on the contrary, when economic growth rate dropped
dramatically to 4.3% in the forth quarter of 2000, if that mechanism had worked, extreme
variations of loan growth rate and that sides effects could had been at the minimum.
As mentioned above, bank loan as itself has a nature of procyclicality. The problem is that
this sort of procyclicality with practicing Basel II will be bigger. Under Basel II, the amounts of
necessary capital of financial organizations are sensitively affected by their possessed assets.
Thus, as growing sensitivity of risks, it can cause a side effect called procyclicality. The first
reason is that “attained” loss of loan gets bigger when economic depression appears.
Dishonor of loan assets increases and the burden of saving applications money for deadloans increases as well. This sort of attained loss and “potential” loss mean that bankruptcy
risk gets higher; it acts as a factor which decreases capital adequacy ratio. As declining
capital adequacy ratio in the economic depression period, banks will not have enough loan
decoys and that can worse economic condition. This kind of side effects will be bigger as
capital adequacy ratio responds sensitively. That is why Basel II has bigger procyclicality
rather than Basel I.
Accordingly, declining capital adequacy ratio of banks may slow providing loans and this
needs explanation. As a matter of fact (in economic depression), there is no reasons that
bank‟s actions to raise capital adequacy ratio should be linked with dull loan. The reason is
that there are many ways to raise capital adequacy ratio. Firstly, bank‟s capital adequacy
ratio came out of dividing self capital by risk weighed assets, so that four ways can be come
up (Jinik, 2004). In other words, (i) expanding fundamental capital, or (ii) expanding
complement capital can increase self capital, which is a numerator of capital adequacy ratio.
Also, (iii) altering asset structure to lower average risk added value, or (iv) reducing asset
scale by the times of loan to reduce scale of risk weighed assets, which is a numerator of
capital adequacy ratio. However, in depression, self capital supplement cost will increase,
because bank‟s profit and growth rate is basically falling. Thus, the first method makes
fundamental capital expansion difficult through retained earning and paid-in capital increase
and also, subordinated premium increases so that second method, expanding supplementary
capital by publishing subordinated bonds also becomes difficult. As mentioned above, the
third method, altering asset structure to raise safety becomes difficult in economic depression.
The reason is that banks are likely to raise their lowered capital adequacy ratio in depression
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
period, so superior assets, short-term assets, securities assets and other stable assets
supply costs increase. Finally, in depression period, the most reasonable method is the forth
one that restricting loan expansion to raise capital adequacy ratio.
Many researches on the procyclicality of Basel II have been made. These studies mostly set
the certain period of time in the past (especially depression period) and applied Basel II in
that period to estimate how much needed capital adequacy increases. Typically, Kashyap
and Stein (2004) estimated needed capital growth rate from 1998 to 2002, that result can be
varied by the kinds of loan assets and the methods, however its growth rates vary from
minimum 1.72% to maximum 161.91%. This means that needed capital can be 2.6 times
much larger by applying Basel II. <Table 1> summarizes results of previous study which had
a similar ways with a study of Kashyap and Stein (2004) to prove result of needed capital
growth rate by applying Basel II. Each study has different measures to research, however
many studies prove procyclicality of Basel II.
<Table 1> Studies on Capital Growth after Basel II
Needed Capital
Researchers
Nation
Period
Max. Growth Rate (%)
Ervin and Wilde(2001)
USA
1990-92
20
Segoviano and Lowe(2002)
Mexico
1995-99
69.8
Catarina-Rabell, Jackson, and Tsomocos(2003)
USA
1990-92
53.2
Jordan, Peek and Rosengren(2003)
USA
1996-01
280
Rosch(2002)
USA
1982-00
15
Source: Kashyap and Stein(2004), Table 3 rearranged.
III. Countermeasures of Deposit Insurance System
1. Previous Studies
Even though there are many studies about procyclicality of Basel II, not many studies on
analyzing countermeasures of deposit insurance system. Pennacchi(2005), Jarrow, Madan
Proceedings of 10th Annual London Business Research Conference
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and Unal (JMU, 2006) study this problem exceptionally. Pennacchi stated that both capital
restriction and deposit insurance worsen procyclicality of bank loan due to side effects of
adopting risk standard. Pennacchi compared two policies to research it. In other words, (i)
capital adequacy ratio is worked with risk standard and deposit insurance is fixed, (ii) Leaving
bank‟s capital adequacy ratio alone, instead imposing differentiated deposit insurance,
depending on the sort of risks. Under these two policies, when economic depression made
capital adequacy ratio fall into no more than regulated level, Pennacchi compared diminution
amounts and result presented that asset diminution amount came out of increased insurance
fee in the standard of risk deposit insurance system is rather smaller than asset diminution
amount came out of raised capital adequacy ratio in the standard of risk capital adequacy
ratio system.
Focusing on Jarrow, Madan, and Unal (JMU, 2006), they suggest a system which is not only
countercyclical but also safe enough to impose deposit insurance. Their thesises are just the
same with Pennacchi‟s thesis. In other words, current American differentiated insurance
system such as American deposit insurance system has procyclicality so this study is likely to
find out countermeasures of procyclicality. JMU finally suggested a countercyclical deposit
insurance system: this is basically a combination of two devices. One imposes much more
when economic condition is good and much less when economic condition is bad, and the
other one alleviates insurance fee when deposit insurance gets to the certain level, or
expected fund. The reason for not harnessing it as risk-based deposit insurance despite of
counter-cyclicality is that it always guarantees the worst situation of deposit insurance.
In JMU‟s countercyclical deposit insurance system, t is certain point (for example, 2008), Pt
is deposit insurance of bank industry, Ct is scale of deposit insurance, and Lt is the total loss
of deposit insurance. The formula for deposit insurance premium is set as follows:
̅(
x.
/)
(
)
(1)
Here, ̅ indicates deposit insurance when deposit insurance is not in a countercyclical
system (or when both
and
are both zero,) C is the level of planned fund,
is elasticity
that insurance fee alleviates when
reaches at its goal. For instance, when all other
conditions are fixed, when deposit insurance fund ratio (Ct/C), which is compared to its
planned fund, increases from 1 to 1.01, or 1%, deposit insurance decreases
% compared
to the former value. By the same token, when loss, Lt (exactly 1+Lt) increases 1% from the
former value, deposit insurance decreases
% compared to the former value.
Proceedings of 10th Annual London Business Research Conference
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According to JMU, the equation (1) should meet the following requirement.
,
* (
)
+
-
( )
This requirement states that whatever point it is from the present time to point T, possibility
of exhaustion of deposit insurance (or deposit insurance decreases less than zero) should be
p. In other words, when the scale of deposit insurance at the beginning point of period t is Ct,
this lengthens as much as its interest rate, or rt so that it becomes Ct(1+rt) at the end of t.
Moreover, when you add deposit insurance, Pt, and subtract loss, Lt, that will get to the scale
of deposit insurance at the end of t. Whatever point it is to the future T, this requirement
restricts it not to get less than zero by p. Thus, meeting both formula (1) and (2) means that
parameters of formula (1), ( ̂ , , ) should meet the requirements of formula (2). Finally,
according to JMU model, deposit insurance is not in the fair condition, however it restricts
exhaustion of deposit insurance so that it is a risk based deposit insurance system.
2. Current Korean Deposit Insurance System
The Korea Deposit Insurance Corporation (KDIC) is applying planned fund and
differentiated deposit insurance systems to improve current deposit insurance system.
Planned fund system pursues long-term natural growth ability of deposit insurance and gets
rid of the uncertainty of financial organization‟s insurance payment. As you can see form
<table 3>, which shows deposit insurance premium rates for each financial institution, good
amount of fund resource are saved for each institution except for savings banks. Even
though funds are saved, KDIC decided to maintain sustainable long-term natural growth of
funds rather than lowering insurance fee. Furthermore, current deposit insurance law does
not guarantee the certain level of savings fund‟s amounts so that financial organizations
cannot tell how much to pay from the next day of payment. If practicing planned fund system,
financial organizations are forced to save funds (paying constantly despite of no loss of fund);
however financial organizations could minimize the uncertainty by setting the lucid planned
level. On the other hand, differentiated deposit insurance system is causing the problem of
fairness among each industry by imposing the same insurance rates, except for banks,
insurances, securities, and other financial organizations. Moreover, current insurance rates of
each industry do not reflect its own traits and risks.
<Table 2> Deposit Insurance for Korean Financial Institutions
(as of Dec. 2006)
Proceedings of 10th Annual London Business Research Conference
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(Unit: a Billion won)
Life
Nonlife
Life
Savings
Insurance
Insurance
Annuity
Banks
Banks Securities
Insurance Rate
0.1%
0.2%
0.3%
0.3%
0.3%
0.3%
2,182
149
1,535
308
12
△882
Composition Scale of
Funds
Source: The National Assembly of Finance and Economy Committee (2007)
KDIC once announced the result of a research in May 2007 to apply planned fund and
differentiated insurance rate systems. The main topics are categorized into four plans. First
of all, following the system of public capital redemption fund, current special grant system will
work as usual. Past loss is paid partially by special grant system, so that KDIC runs it
separately from planned fund system which prevents future loss. Secondly, the application
unit of planned fund policy is run separately, depending on area and the application unit of
planned fund policy of each area should cover potential outside loss by setting fund reserving
rate (scale of fund savings/risk exposing money). Thirdly, if the loss appears right after
starting reserving fund, that reserved fund can cover the loss and then, insurance rate,
expected time will be set. Lastly, differentiated insurance rate will be set by the scale of
planned fund of each area and the estimated average insurance rate which reflects own
authority‟s potential risk.
KDIC stated that guaranteeing proper data to judge the healthiness of financial
organizations for planned fund and differentiated insurance rate systems is a big assignment.
Especially, when it comes to differentiated insurance rate, the current management
evaluations and financial infrastructures of the authorities are emphasized. To authors‟
judgment, lots of information (pillar 1) related with inner level system which is created by
financial organizations after practicing Basel II and lots of information (pillar 2) after
reinforcing monitoring of risk managements will be useful sources.
3. Countermeasures of Deposit Insurance Policies
(1) Countercyclical Deposit Insurance Rate System
As discussed above, current Korean deposit insurance authorities are pursuing a variety of
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
preparations related with planned fund and differentiated insurance rate systems, however
the authorities do not care about procyclicality of differentiated insurance rate system (or
Basel II). However differentiated insurance rate policy is procyclical as it self, current Basel II
and differentiated insurance rate policy can mutually cause the side effects to enlarge
business fluctuation due to the procylicality of both capital adequacy restriction and deposit
insurance systems. Thus, under current Korean situations which are based on Basel II,
planned fund and differentiated insurance systems, this study is looking for the
countermeasures to minimize the procyclicality of capital adequacy restriction and deposit
insurance systems and also to connect the risks with planned fun and insurance rate.
The deposit insurance policy we suggest can be interpreted as “countercyclical risk-based
deposit insurance policy.” Firstly, in the time manner, when economic depression (prosperity)
comes, the burden of insurance decreases (increases) so that it is timely countercyclical, at
the same time, when insurance fund gets to the certain expected level, the burden of
insurance decreases as well. Thus, in the each bank‟s case, differentiated insurance system
is applied so that insurance rate of banks with the big (small) risk will be a lot higher (lower).
Consequently, in the total insurance aspect, deposit insurance of banks works inversely with
the risk, but when total insurance is distribute to each bank, deposit insurance of banks
works proportionately with the risk.
There must be some establishments before explaining this model, firstly, planned fund
policy is not the absolute value however, and fund reserving rate (deposit insurance
fund/deposit rate) will set its goals. Also, planned reserving rate does not mean a certain
value, however planned reserving rate is based on the scope, and then minimum and
maximum are both cL and cH. In this situation, at the point of t, deposit insurance rate
(insurance fee/deposit rate) of total bank industry is set as follows.
v
{
̅(
x.
L
/)
w
.w/
whe c < cH
(3)
whe c ≥ cH
In this equation, ̅ is deposit insurance rate when deposit insurance is not countercyclical
(or
and
are both zero), ct is fund reserving rate at the point of t, wt is BIS capital
adequacy ratio of total bank industry at the point of t, w is BIS based threshold. Also
is an
elasticity when deposit insurance fund reserving rate gets bigger than the infimum of planned
reserving rate, insurance rate alleviates,
is an elasticity when BIS rate decreases
(increases) rather than threshold (w), insurance rate decreases (increases). For example,
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
supposing other requirements are fixed, when the magnification ( ⁄ L ) of fund reserving
rate increases from 1 to 1.01, or 1% (or when fund passes over planned infimum 1%),
deposit insurance rate decreases
% compared to the former result. Thus when BIS ratebased contrast magnification (w ⁄w) decreases from 1 to 0.99, or 1%, deposit insurance rate
decreases
% compared to the former result. On the other hand, when deposit insurance
fund reserving rate passes over maximum of planned reserving rate, deposit insurance rate
becomes zero and the extra fund will be rebated. In this case, as long as banks do not make
fund loss, insurance fee is not paid and the interest profit from reserving fund is paid in the
form of rebate.
(2) Connection with BIS Capital Adequacy Ratio
Comparing equation (3) with the original JMU equation of (1), fundamental ideas are same,
but there are some minor differences. The biggest difference is that in equation (1), JMU
alleviates insurance fee following the amount of loss (Lt). On the other hand, Korea uses BIS
capital adequacy ratio rather than using the amount of loss. In short, while JMU alleviates
insurance fee by the “actualized” loss, we used BIS capital adequacy ratio which reflects
“potential” risk. The biggest reason that Korea used capital adequacy ratio rather the amount
of loss is that Korean bank industry has at least low frequent loss of deposit insurance.
When it comes to the United States, as you can see in <Figure 3>, banks make
bankruptcies annually so that they make fund loss no matter how many banks they have.
Except for 2005 to 2006, 75 year history of American deposit insurance system has made
bankruptcies of banks absolutely without any exceptions. It is no surprise that not small
number of financial organizations makes bankruptcies annually, because the number of
financial organizations in the United States was estimated 8,571 in the standard of 2007.
One the other hand, in Korean case, even though Korea made a lot of bankruptcies due to
the financial crisis of 1997 and the biggest ray-offs, however that just had happened in the
extreme economic situation. Due to the small number of banks in Korea, normally one
bankruptcy means much. In this situation, there must be some problems as equation (3)
includes the loss of deposit insurance fund as variables with the similar way of formula (1). In
reality, actual loss will rarely happen and then (when the planned reserving rate has not been
reached), there will be no change in insurance rate during the period. In this case,
countercyclical deposit insurance system that we aimed cannot be made.
<Figure 3> US Bank Failures and Loss of Deposit Insurance
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Source: FDIC (2007)
The most important reason that BIS capital adequacy ratio is used rather than using the
amount of loss of deposit insurance fund is that BIS based can be a better way compared to
loss based when it comes to making deposit insurance fee countercyclical. The beginning of
the argument is to make up for procyclicality of Basel II, and the reason is that BIS ratio
became much sensitive under Basel II so that adjusting deposit insurance fee by BIS ratio
based would be the direct countermeasure. As a matter of fact, the loss of deposit insurance
is already actualized so that the burden of insurance fee gets decreased only after the
bankruptcies of banks. Thus, when the risk gets increased, fast preemptive actions would be
much better. In this point, Basel II made banks sensitive on BIS ratio with the risk, adjusting
insurance fee by Basel II ratio would be more future oriented way.
Actually, as you can see <Figure 4> which reflects the transition of BIS ratio of Korean
general banks, BIS ratio had been declining before 1997 financial crisis. If supposing the
same situation, JMU way makes deposit insurance fee alleviate after 1998 when banks start
to bankrupt, however BIS ratio based way guarantees the alleviation of deposit insurance fee
much before that.
<Figure 4> Capital Adequacy Ratios of Korean Banks
Proceedings of 10th Annual London Business Research Conference
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Source: Financial Supervisory Service, Monthly Report of Financial Statistics
(3) Derivation of Parameters
Among various variables and parameters in the right side of equation (3), except for c and w,
deposit insurance authorities should determine or estimate the proper numeral value. The
focus of this chapter is what measures should be determined under the certain requirements
and principles. As explained above, what equation (3) suggested does not consider the
possibility of bankruptcies of banks when it comes to the determination of insurance rate.
However, the bankruptcies of banks and the loss of deposit insurance fund affect insurance
fee rate. Because fund reserve ratio (ct) is included in formula (3) as a variable. Two cases
are considered; let us look at the first case which makes loss after fund gets to the planned
scope. When looking Korean bank industry, if one bank makes a bankruptcy, the possibility
that fun reserving rate would go down under the minimum of the planned scope can be made
so that insurance fee rate will increase immediately. The other case to generate loss is that
loss is made before the fund gets to the planned scope. In this case, the loss does not affect
immediate insurance fee rate, but future insurance fee rate. Or, if that loss did not exist, fund
could have reached the planned reserving rate much faster so that the alleviation of
insurance fee could have made, however the loss made reaching period longer so that it
affects insurance fee rate. After all, considering that the fund loss still influences premium
rates, our model of equation (3) also needs a condition like equation (2) of JMU. As
mentioned above, ̅ , ,
and other factors in the JMU model are determined by formula
(13). However, in the case of Korean bank industry, modeling loss is actually a difficult task.
As mentioned before, the number of Korean banks is small, besides the time that made loss
is concentrated on the financial crisis, an extreme period. Accordingly, Korea should take the
appropriate method rather than the way of JMU.
First of all, let us think about the target reserve ratio. If the target reserve ratio is set by
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
using past loss data, we need to estimate the loss distribution of fund and then surmise the
certain level of loss of deposit insurance fund to make up so that a way that takes the proper
planned reserving level would be taken. However in the Korean bank industry‟s case which is
difficult to estimate the loss distribution, it is better to set its goal such as, “fund that covers
one middle-big sized of bank (or two middle-small sized of banks).” This way is much direct
and makes the scope of covering deposit insurance fund certain. A financial crisis like the
Korean economic crisis in the end of 1990s cannot be covered by deposit insurance fund so
that too much fund plan will not be reasonable so, the above level will be the proper level.
This is very simple, however it needs to consider the possibility of bankruptcies,
disorganization fee and other risks so that it could be considered as a risk based way.
In this way, as we determine the target range of fund reserve ratio (for instance, 1.5% to 2.0%
of deposit), we also need to set the time to reach the target. Even though the required time is
set, this period of time cannot absolutely guarantee its success. Because, when loss appears
during the process of achieving the goal, the time will be delayed. However, planning the
required time will “conditionally” help reducing uncertainty and calculating reasonable
insurance fee. “Conditionally” means that the case which does not make loss until the plan
has not been satisfied and the other case which makes loss are divided. Firstly, suppose that
loss does not happen, then set the planned period, and then if loss appears, revision of the
plan is added. This way is a very appropriate way to Korean bank industry which is hard to
estimate or predict the loss of fund.
As explained above, after setting the planned reserving rate and the planned period, the
value of ̅ , ,
should be determined. When it comes to ̅ , ̅ means deposit insurance
rate unless deposit insurance is procyclical so that current value (or 0.1%) or similar level
would be fine. After determining the value of ̅ , appropriate value of
and
should be
determined to achieve goals in the planned period.
Let us look at countercyclical deposit insurance system through simple calibration. Firstly,
the minimum and maximum of the planned reserve ratio are 1.5% and 2.0% compared to
deposit. Also, the beginning point of the fund reserving rate was supposed as 0.58 which is
from the estimation value of the end of 2007, and the scale of deposit was supposed as fixed
which is from the level of the end of 2007. Two cases were compared, the one case
maintains the current insurance rate (0.1%) and the other is a countercyclical system that
was represented as formula (14). Deposit insurance is annually renewed to impose, also
insurance fund makes interest and interest rate was fixed as 5% in the overall time period.
Under these suppositions, in the case of maintaining the current insurance rate, nine years
are used to get to the maximum (2.0%) of the planned reserving rate when there is no loss.
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
Or, if the beginning point is t=1, the planned level should be satisfied in the end of t=9.
By benchmarking the fixed insurance rate system, the second case, countercyclical system
was assumed. The BIS ratio was supposed as 12.50 which are similar to the actual value of
the end of 2007. To observe countercyclical effects of deposit insurance fee rate, a situation
that BIS ratio annually decreases by 0.5% to 10.0% and reversely, BIS ratio annually
increases by 0.5% after t=6 was created. Lastly ̅ =0.1% and w=11% are settled. Under
these factors, the same point with fixed insurance fee rate, or the end point of t=9,
and
which can get to the supremum of the planned reserving rate are decided. As a result,
=1.7 and
=2.3 can get to the goal.
<Figure 5> shows the results of calibration. First, (a) of this diagram shows the transition of
BIS ratio and countercyclical insurance fee rate with the current fixed insurance rate. In
advance, in the countercyclical system, insurance rate is relatively higher than fixed
insurance rate before t=4. The reason is that BIS ratio is higher than the standard line, 11%,
and when it is t=5, BIS ratio decreases under 11% so that insurance rate goes down under
0.1% as well. When comparing the countercyclical insurance rates of t=5 and t=7, even
though both BIS ratios are the same, insurance rate of t=7 is a bit lower. That means fund
reserving rate passes over the minimum of the planned scope after t=7, so that the burden of
insurance fee started to alleviate. After all, when comparing countercyclical insurance fee
rate and fixed insurance fee rate, the former one has bigger insurance rate rather than fixed
insurance fee rate when BIS ratio is good, and as BIS ratio gets bigger, that amount gets
increased. On the other hand, when BIS ratio gets worse or gets to the planned level,
countercyclical insurance fee rate gets smaller rather than fixed insurance fee rate. Partly, (b)
of this diagram shows the transition of deposit insurance fund reserving rate. According to (b),
countercyclical insurance fee rate has relatively higher insurance fee rate in the beginning of
the total period to get to the goal much faster, and after the middle of the total period, that
speed is getting dull.
<Figure 5> Calibration Results of Countercyclical Deposit Insurance Premium Rates
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
(a) Transition of BIS Capital Adequacy Ratio and Deposit Insurance Rates
(b) Transition of Deposit Insurance Fund Reserve Ratios
Note: Fund reserve ratios at the beginning of each period
IV. Summary and Conclusion
Basel II aims at fortifying stability of financial system of an economy by strengthening risk
management of banks. In this sense, it is paradoxical that the side effects of Basel II include
procyclicality. Pursuing financial stability under Basel II may amplify economic fluctuation with
procyclicality. As Basel II achieves its goal successfully, the procyclicality problems can be
worse.
In this study, we suggest a countercyclical deposit insurance rate system to neutralize the
procyclical problems of Basel II. Korean authorities are preparing target fund and
differentiated insurance rate system to solve the problems of current deposit insurance.
This study suggests ways to neutralize procyclicality of Basel II. With economic depression, it
alleviates the burden of deposit insurance premium of banks, while with economic boom, the
burden of insurance premium can be set bigger. We suggest using BIS capital adequacy
ratio as an indicator of economic condition. The main purpose of this study is to study how to
Proceedings of 10th Annual London Business Research Conference
10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8
make up for procyclicality of Basel II and, since BIS ratio becomes more sensitive under
Basel II, adjustment of deposit insurance premium rate with BIS ratios would be very
reasonable. Also, since BIS ratio is not the real loss, but as an index of potential risk,
adjusting deposit insurance rate with BIS ratios would be also much preemptive measure.
Total premiums of deposit insurance for banking industry can be imposed countercyclical,
while individual bank will have differentiated premium rates. For differentiated insurance rates,
there are various issues to consider carefully including risk measurement, number of levels
and the level of differentiation; however, the main assignment is to accurately measure the
risk of each bank. This should work properly to distribute the total amount of deposit
insurance premiums of banking industry to each bank. To do that, a system that evaluate
current risks as well as future bankruptcy risks is required. In this sense, Basel II provides a
new opportunity to the deposit insurance. Under the past agreement, loan asset was not
differentiated according to debtors‟ risks, so that BIS capital adequacy ratio only worked as
an index to measure capital propriety. However, under Basel II, all loan assets are evaluated
in detail and the risks of each bank as well as the total banking industry would be analyzed.
Especially, by uniting Basel II relevant data of all banks, risks of banks‟ customers (or debtors
such as corporations and households) would be monitored. Then, an analysis of
concentration risk which could not be evaluated before with only banks‟ data can be
performed.
A sophisticated analysis on the differentiated insurance premium rate system is beyond the
scope of this study. However, when the risk of individual bank is measured, fundamental
management principle is simple: imposing high (low) insurance rate on high (low) risky banks.
In this way, the total amount of deposit insurance premium of banks and economic risks work
inversely, while individual insurance premium for a bank and the economic risk move
proportionally. Eventually, the function of differentiated insurance rate system which is to
impose fair insurance premium is realized and, at the same time, it also helps neutralizing
procyclicality problem of Basel II.
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Proceedings of 10th Annual London Business Research Conference
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