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 10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8 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 10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8 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 10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8 (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 Proceedings of 10th Annual London Business Research Conference 10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8 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 10 - 11 August 2015, Imperial College, London, UK, ISBN: 978-1-922069-81-8 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. References Choi, Pilsun, "The Estimation of Proper Deposit Insurance Rate - Madan․Unal (2003) Based on Model-," KDIC Financial Research 5 (2004): 5-23. Federal Deposit Insurance Corporation (FDIC), Annual Report, 2007. 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