Saturday, June 15, 2024

“When it rains, it pours”- the new deposit insurance and its discontent


The Ethiopian banking sector has undergone significant changes in recent years, aiming to create a stable financial system that supports economic growth. One of the key developments in this regard is the introduction of the deposit insurance scheme. This article explores the impact of the deposit insurance scheme on the Ethiopian banking sector, considering its benefits, challenges, and potential drawbacks. Through a comprehensive analysis of various factors, including the regulatory framework, funding mechanisms, and coordination with fiscal authorities, this article aims to assess the effectiveness of the deposit insurance scheme in promoting financial stability and protecting depositors.
The Ethiopian economy has shown positive attributes, driven by industry, private consumption, and investment. The African Economic Outlook (AEO) and the International Monetary Fund (IMF) have predicted GDP growth of 5.8% and 6.5%, respectively, for 2023. These figures reflect the overall health of the economy and its potential for growth. However, challenges such as inflation, the fiscal deficit, and unemployment persist along with other macroeconomic setbacks.
Inflation is projected to decline to 28.1% in 2023, according to AEO, following the peace dividend. However, recent figures from the central statistics authority show inflation at 30.8% for the past month alone. The fiscal deficit is projected to grow to 3.1% in 2023, driven by improvements in domestic resource mobilization and the resumption of donor inflows. Government debt is expected to continue rising, reaching around 62% of GDP in 2023, according to IMF projections. The fiscal deficit growth is a concern for the government’s ability to respond to economic crises and financial instability. Various measures, such as raising taxes, improving tax collection, and introducing new taxes, along with spending cuts on non-essential programs and services, are being implemented to address the deficit. However, it is crucial to ensure that spending cuts do not come at the expense of essential services such as healthcare, education, and critical infrastructure.
As a resolution to the continuing challenge, the government needs to implement measures such as raising revenue, improving fiscal consolidation strategies, and resuming donor inflows. However, it is crucial to ensure that these measures do not disproportionately burden disadvantaged groups and widen inequalities, as there have been recent instances in the economy that have imposed financial constraints on various fronts. For example, the general public has been affected by property taxes, while banks have been impacted by deposit insurance schemes.
Unemployment remains a persistent challenge, particularly among youth and women. As the economy recovers from multifaceted challenges such as reconstruction, rehabilitation of internally displaced persons (IDPs), and resolving conflicts, the unemployment rate is projected to remain high in 2023. To support economic recovery, the government continues to pursue expansionary fiscal policies, while the National Bank of Ethiopia (NBE) maintains accommodative monetary policies.
A stable financial system with well-functioning banks and capital markets is vital for companies to obtain financing, individuals to save and invest, and the government to finance its operations. These factors contribute to economic growth, innovation, and competition. However, high public debt poses a risk to financial stability and the government’s ability to respond to economic crises. Access to financing, lower barriers to entry, and a supportive business environment are crucial for promoting innovation and competition. While these policies contribute to positive economic prospects, some measures may have adverse consequences. It is essential to balance the removal of bottlenecks and the improvement of production processes with their potential implications for the financial sector.
The deposit insurance scheme in Ethiopia aims to mitigate systemic risk and ensure the protection of depositors in the event of a banking crisis. This scheme offers a wide range of benefits, including financial stability, increased public confidence in the banking system, promotion of financial inclusion, deepening of financial markets, and improved access to financial services. It also encourages responsible risk management by maintaining adequate capital reserves and effective risk management systems.
Deposit insurance schemes worldwide adhere to international standards developed by organizations such as the International Association of Deposit Insurers (IADI), the IMF, and the Basel Committee on Banking Supervision. These standards cover various aspects, including coverage, funding, governance, transparency, risk-based premiums, the claims process, and coordination with other safety net arrangements.
Deposit insurance schemes should provide coverage for all types of deposits in a timely and efficient manner, up to a specified limit. The coverage limit should be regularly reviewed to ensure its adequacy in protecting small depositors. The current proposed limit of 100,000 ETB does not take into account the account productivity of banks, such as the deposit per account. This directive was open for consultation and under formulation, with the possibility of endorsement without any fundamental changes. Funding mechanisms typically involve contributions from member banks based on their risk profile and investment income. The proposed directive assigns premiums to cover expected losses of the deposit insurance fund, which are based on the average deposit held during a specific period (March 30th, 2023). However, it does not take into account factors such as segmentation, the risk profile of banks, tenure, financial strength, and the complexity of premium setting. This includes considerations such as the nature of the deposit (insured versus total deposit), current account, and compulsory savings versus other savings.
Transparency is crucial in the operations of deposit insurance schemes, with clear and consistent communication to depositors and other stakeholders. Risk-based premiums, based on the level of risk associated with member banks’ operations, ensure a fair distribution of contributions. The claims process should be transparent, efficient, and timely to provide depositors with a safety net during times of crisis. These serve as a partial link to the proposed directive that banks are closely monitoring as it is about to be implemented. However, this directive fails to address all of the important concerns that have been raised by stakeholders. The government is pressuring banks to collect funds within 30 days of the directive’s implementation, and severe penalties will be imposed on banks that fail to comply.
Deposit insurance schemes should have a sound governance and management structure with clear lines of accountability and responsibility. Coordination with other safety net arrangements, such as central bank liquidity support and lender-of-last-resort facilities, is essential to promoting financial stability and protecting depositors effectively. Hence, to avoid placing unfair burdens on the disadvantaged and widening inequalities, deposit insurance schemes should implement equitable policy instruments. Trade-offs between different objectives may be necessary to ensure fairness in spending cuts.
Ensuring the fairness of spending cuts can be challenging and may require careful consideration of their potential effects on different groups. It is crucial to prioritize essential services, protect social safety nets, and increase transparency in both the budget process and tax expenditures. This helps to ensure that spending cuts are made in a fair and equitable manner. Introducing a deposit insurance scheme requires efforts to increase education, awareness, and financial literacy among the public. These initiatives are essential for promoting understanding of the deposit insurance scheme, its limitations, and the benefits it provides to depositors and the overall financial system. Financial literacy programs can address potential limitations and enhance public trust in the banking system. The implementation of the scheme will add further pressure on banks, which are already burdened with a 1% commitment to DBE as well as the purchase of 20% bills from NBE and other regulatory requirements. These and other flaws in the economy exacerbate the situation.
Deposit insurance schemes can have potential drawbacks, including moral hazard, increased costs to banks and depositors, limited effectiveness in smaller and less diversified banking systems, and limited coverage for all depositors. It is crucial to carefully consider these drawbacks and design the deposit insurance scheme in a way that maximizes benefits and minimizes potential adverse effects.
Calculating risk-based premiums can be complex, requiring significant resources and expertise. It is not as simple as considering the average deposits of banks at a certain point in time. New banks may face challenges in managing the administrative burden and limited capacity to assess and manage risks. Inconsistencies in risk assessments between the deposit insurance scheme and member banks can lead to disagreements over appropriate premium rates and reduce the effectiveness of the scheme in promoting financial stability.
Reserve requirements and deposit insurance schemes play complementary roles in promoting financial stability. Reserve requirements ensure that banks hold a minimum level of reserves to meet their obligations and promote monetary policy objectives. Deposit insurance schemes provide a safety net for depositors, reducing the likelihood of bank runs and promoting public confidence in the banking system. As both options share common ground as policy tools, the new plan should consider the potential for revising the reserve requirement. Alternatively, the new plan could be adjusted to reduce the initial premium from 0.05% and the annual premium from 0.3%.
Both reserve requirements and deposit insurance schemes can impact banks’ profitability and regulatory burden. Higher reserve requirements reduce the amount of funds available for lending, potentially impacting banks’ profitability and growth. Deposit insurance premiums can also affect banks’ profitability, especially if based on a risk-based system. New banks may face challenges in managing the regulatory burden, which can result in reduced affordability for customers.
Reserve requirements and deposit insurance schemes contribute to promoting public confidence in the banking system, ensuring adequate liquidity, and protecting depositors in the event of a bank failure. These tools work in conjunction with other measures, such as lender-of-last-resort facilities as outlined above and supervisory tools, to maintain financial stability. In the last six months, however, there has been a significant shortage of funds available to meet customer demand. This is in contrast to the recent statement that denied the existence of this issue. Given the current situation, where there is limited fiscal space and resources and a fragmented banking system, it can be difficult to coordinate between deposit insurance and fiscal authorities. On-going engagement, cooperation, and evaluation are necessary to effectively address these challenges.
The deposit insurance scheme benefits commercial banks by providing a safety net for depositors and promoting public confidence in the banking system. This, in turn, can reduce liquidity risk and the likelihood of deposit outflows during times of stress. However, the scheme also increases the regulatory burden on banks, particularly smaller or new ones, which may impact profitability and customer affordability. It also creates a regulatory burden for banks, impacting their ability to focus on core business activities. It is crucial to design risk-based premiums that incentivize responsible behaviour and balance risk with affordability. This ensures that banks with a lower risk profile pay lower premiums, promoting sound risk management practices and reducing moral hazard.
The calculation and administration of risk-based premiums can be complex, requiring sufficient resources and expertise. This is the missing component when scrutinizing the directive itself. Smaller banks may face challenges in managing the administrative burden and have limited capacity to assess and manage risks. It is important to address these challenges to ensure that risk-based premiums are fair, adequately reflect the risk profile of member banks, and maintain the financial health of the deposit insurance fund. The deposit insurance scheme can impact government finances by increasing spending and reducing revenue. Maintaining a sound banking system through adequate risk management and capitalization can minimize the need for government support for the deposit insurance scheme. Fiscal discipline is crucial to promoting financial stability and reducing the likelihood of government intervention.
The establishment of an independent regulatory authority is crucial for effective supervision of the deposit insurance scheme. This authority should have clear lines of accountability and responsibility, ensuring transparency and fair treatment for all stakeholders. Effective supervision and enforcement contribute to the sound operation of the scheme and promote financial stability. The authority lacks a well-defined strategy for utilizing funds, identifying investment areas, managing funds obtained from both conventional and interest-free banking, and establishing a compensation framework. These critical flaws need to be addressed promptly.
The timing of introducing a deposit insurance scheme is crucial. It should be based on the state of the banking system, the regulatory environment, and public awareness and trust in the banking sector. Before implementation, a comprehensive regulatory framework should be in place, accompanied by public awareness campaigns to ensure understanding of the scheme and its limitations. Instead of hastily implementing a directive that has loopholes in all directions, which could lead to unforeseen consequences in the near future, it is important to carefully consider the purpose of the fund.
The deposit insurance scheme imposes a regulatory burden on banks, particularly smaller ones, requiring resources for compliance activities. This burden can impact profitability and affordability, potentially affecting access to banking services. Additionally, there may be potential fiscal costs associated with supporting the deposit insurance fund in the event of a large-scale bank failure. To maximize the benefits of the deposit insurance scheme and minimize potential drawbacks, it is crucial to address challenges such as complexity in risk-based premium calculations, administrative burdens on smaller banks, type of deposit, and potential moral hazard. Regular reviews and evaluations of premium rates, coordination with other safety net arrangements, and on-going improvement efforts are necessary. The region’s similar economy, which employs different methods, should be competitive. For instance, Kenya and Tanzania have set their skim rate at 0.15%, whereas Uganda has set it at 0.2%. Rwanda, on the other hand, only applies a skim rate of 0.1% on uninsured deposits. This shows that our percentage is significantly higher than any standard out there. In many cases, it may be more financially feasible to purchase insurance premiums from re-insurers instead of following the current proposal.
To ensure the effective implementation of the deposit insurance scheme, it is recommended that a comprehensive legal and institutional framework be established. This should include an independent regulatory authority that can work with all stakeholders to address the aforementioned challenges. Public awareness campaigns and financial literacy programs are essential to promoting understanding and trust in the scheme. It should not just be a plan but rather be implemented without delay. Continuous evaluation, coordination, and improvement efforts are necessary to maximize the benefits and minimize potential drawbacks of horizontal communication rather than relying solely on top-down communication.
We all agree that the deposit insurance scheme in Ethiopia is a crucial step towards building a stable financial system. Continuous evaluation and improvement are necessary to address emerging challenges and adapt to the evolving needs of the banking sector. International cooperation and adherence to best practices and standards contribute to the effectiveness of the scheme in promoting financial stability and protecting depositors.

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