Investment Activity of the Deposit Insurer

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Deposit Insurance Conference - Basel, Switzerland, 22 - 25 October 2001.

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Investment Activity of the Deposit Insurer

  1. 1. BANK FOR INTERNATIONAL SETTLEMENTS International Conference on Deposit Insurance Basel, October 22 – 24, 2001 Session 7: Investment Policies for Deposit InsurersInvestment Activity of the Deposit Insurer Prepared by Mileti Mladenov Chairman of the Management Board Deposit Insurance Fund Bulgaria
  2. 2. 2 Investment Activity of the Deposit Insurer Investment: Requirements and ConstraintsInvestment activity is typical of еx-ante systems as well as of combined systemscharacterized by preliminary accumulation of funds. To some extent investment isconsidered to be of secondary importance and is even underestimated by some ex-ante systems, consistent with the common legal requirement for security andliquidity of accumulated funds. Security and liquidity of funds proves a top priority,and therefore income on invested funds occupies a subordinate place. This view maybe reasonable for big countries with a stable national currency that is used as aninternational payment instrument. In such countries deposits that are subject toinsurance are denominated mostly in national currency.However, the situation in small countries with closed and unconvertible currencies isdifferent. In these countries individuals and companies hold a portion of theirsavings in national currency deposits and a significant portion in convertible foreigncurrency. This results in foreign exchange risk for the respective component ofdeposits protected by the deposit insurer. Such countries are characterized byspecificity associated with the exchange rate regime, distribution of deposits innational and foreign currency, deposit insurer’s risk evaluation, etc.Let me formulate the following hypothesis: despite the security and liquiditypriority, a deposit insurer under an ex-ante system should make efforts to manageaccumulated funds as well as the insured bank would, if these funds had been left inthe bank’s own portfolio. As such, investment income would be maximized whilestill observing security and liquidity requirements. Practically, this is hard to beachieved but it exists as an implicit requirement, which, I suppose has been realizedby management bodies and managers of deposit insurance schemes.Commonly, investment options are legally formulated leaving little room formaneuvers of the deposit insurer. The status of the deposit insurer as a financialinstitution is not always explicitly defined by law, although it actually acts as suchInternational Conference on Deposit Insurance Basel, October 22 – 24, 2001
  3. 3. 3institution. Provided no bank bankruptcies occur for a long period of time,significant funds may be accumulated in the ex-ante system. In this case this is aquasi-bank or quasi-financial institution as it has to participate almost every day onthe market or, if it uses an agent, to constantly monitor the market.Investment alternatives and solutions are also impacted by the amount of premiumsand investable funds. Internationally, there is a trend towards reducing or eveneliminating required reserves. However, there are a number of reasons to keepsignificant required reserves in many countries. It must not be ignored that depositinsurance premiums together with required reserves constitute a financial burden forbanks. This can result in a distorted interest rate structure and finally, the burden isultimately born by bank customers. Some participant banks in the deposit insurancesystem express an informal discontent both against the heavy cost of insurancepremiums as well as the amount of income generated through the management ofthe insurance fund, despite the fact that participant banks are not the owners of thesefunds from legal point of view.Comparatively low concern in respect of investment and realized income isassociated also with privileges provided for some deposit insurance schemes, e.g.direct access to government securities primary market (if the deposit insurer isauthorized to act as a primary dealer), off-market formation of the investmentportfolio by direct purchases of government securities from the Ministry of Finance,etc. This coupled with a sound convertible national currency makes the status ofcorresponding national institutions quite different, from the status of identicalinstitutions in smaller countries. Therefore, the issue of investment and investmentpolicy of deposit insurers will further stay in the focus of interest for particularcountries. Although this concerns ex-ante systems which are expected to dominatein the future, investment policy is unlikely to be standardized, and deposit insurer’smanagement bodies will have greater freedom in designing their investmentpolicies. Concurrently, the general principle for security and liquidity of funds willsustain its priority, as periods of calmness and lack of bank bankruptcies will beunavoidably followed by periods of increasing rates of bank closures.International Conference on Deposit Insurance Basel, October 22 – 24, 2001
  4. 4. 4Sustaining the value of accumulated funds is of significant importance for countrieswith closed, unconvertible currencies. This issue may be considered in two aspects:preserving internal purchasing power and sustaining the value of funds measured instable foreign currencies.To avoid erosion of funds, investment income should not lag behind the inflationrate or any other index measuring the internal purchasing power. In practice, thisproves impossible to be achieved at any time, since the level of internal interestrates, and particularly, the yield of government securities as a major financialinstrument may be lower than the inflation rate. Real interest rates are very dynamicand sometimes unpredictable in smaller countries with unstable economies andunderdeveloped financial markets.Preserving external purchasing power of the accumulated funds depends on twofactors: the exchange rate of the national currency and international interest rates. Aban on investment in foreign currency-denominated assets may have an additionaladverse effect since the deposit insurer is completely exposed to foreign exchangerisk associated with a possible national currency devaluation against the foreigncurrencies in which a significant portion of deposits is held.In general the deposit insurer’s portfolio includes risk-free and low risk assets withshort maturity. Probably, it may sound quite exotic if a small portion of the portfolio(2% - 3%) is allocated as risk capital to be used for speculative transactions,intended to maximize income, which, for example, may be used for coveringadministrative expenses of the deposit insurer. This alternative was discussed inseveral countries but no information on its practical application is available.Very often deposit insurers manage their investment portfolios indirectly byconcluding agreements with a bank or other institution - a financial intermediary, onformation, maintenance, and management of their investment portfolio. In this caseoverhead expenses of the investing institution decrease. The agent receives acommission or other remuneration. Consequently, it should be decided which of thetwo opportunities is financially more favorable. Undoubtedly, the issue of agent’srisk remains. The degree of risk is different in countries with a stable economy andInternational Conference on Deposit Insurance Basel, October 22 – 24, 2001
  5. 5. 5developed financial system and in emerging market economies with unsoundfinancial systems. However, even in the second group of countries there aresufficient modern financial tools providing opportunities for eliminating orminimizing the agent’s risk.Deposit insurer’s investment activity depends to a certain extent on the amount ofavailable funds. In principle, the bigger fund provides better opportunities forconstituting and managing the portfolio, e.g. in respect of portfolio’s maturitystructure and profitability. This concerns the more general question of the fund’soptimal amount under ex-ante systems. The specificity of each country determinesthe structure, activity and constraints in deposit insurance. Adoption of the rule ofthumb that the minimum amount of funds should be sufficient to cover the risk inthe biggest among medium-size banks and lower than the risk degree in big banksappears to be reasonable. Legislation of individual countries provides for a differentamount of funds, and in general, the prescribed amount reflects the assessment oflegislators, policy makers, experts and the public on the stability and general risk forthe banking system.From institutional point of view, deposit insurer’s investment is usually managed onthe basis of an investment policy, approved by the management body of theinstitution. The investment policy includes principles, goals, strategies, andimportant internal controls. The investment function can be managed by a specialdepartment within the institution or by an agent. In the second case the depositinsurer receives only information about the state of the portfolio and controls thecompliance with agreed terms and constraints. Investment policy design is animportant component in management under ex-ante systems. This document shouldbe of utmost clarity and precision, being at the same time flexible enough to allowusing the market opportunities under the inevitably changing market conditions. Inthis respect, this document is similar to internal documents regulating operations ofbank and nonbank financial institutions.International Conference on Deposit Insurance Basel, October 22 – 24, 2001
  6. 6. 6 Investment Activity of the Deposit Insurance Fund of BulgariaThe first deposit insurance scheme in Bulgaria was established in early 1996. Thisdeposit insurance scheme was based on Directive 94/19/EC of 1994. Actually, thedeposit insurance scheme failed to start normal operations due to the outbreak of thedire 1996 financial crisis when 15 banks, comprising more than 25% of the bankingsystem assets failed. To curb the crisis, extraordinary legislation was adopted,providing for a 100% repayment of the deposits of individuals and a 50% repaymentof the deposits of companies in closed banks from the budget. The DepositInsurance Law was adopted in 1998 and in early 1999 the Deposit Insurance Fund(DIF) was established, operating on the basis of common principles for a partialcover of deposits. The operating deposit insurance system is of ex-ante type withbanks paying annual premiums equivalent to 0.5% of the deposit base (deposits ofindividuals and companies). In case of a bank failure DIF starts repaying insureddeposits not later than 45 days after a bank has been declared bankrupt. By 1October 2001 DIF accumulated approximately USD 48 million in national currency.The deposit insurance system covers accounts both in national and foreign currency,with foreign currency deposits’ equivalent repaid in national currency at the currentexchange rate. Entry and premium contributions are paid by banks in nationalcurrency. Accumulated funds are also invested only in national currency. Thiscauses foreign exchange risk for the portion of funds corresponding to the foreignexchange component of the deposit base. By mid-2001 the share of insured foreigndeposits was 56%. Seventy percent of foreign currency deposits are denominated inUS dollars and the remaining portion is denominated in Euro and other currencies.Given the fact that a currency board was introduced in Bulgaria since mid-1997 andthe German mark was initially set as a reserve currency and later replaced by theEuro, there is no risk for the portion of foreign currency deposits denominated inEuro (at least for the period of fixed exchange rate of the national currency;currently the BGN/Euro exchange rate is BGN 1.95583). To this end, DIF initiatedamendments to the effective legislation intended to remove foreign exchange risk(the amendments have not come in force yet). The amendments provide for paymentof the portion of premiums on foreign currency deposits in the respective foreigncurrency and accumulated funds in foreign currency to be invested in assetsInternational Conference on Deposit Insurance Basel, October 22 – 24, 2001
  7. 7. 7denominated in the corresponding currency. The portfolio should be periodicallyrestructured in order to sustain the correspondence with insured deposits. Bindingforeign currency premiums with foreign currency assets is also reasonable with aview to avoiding open positions, and correspondingly foreign exchange riskassociated with them.In accordance with currently effective legislation DIF invests accumulated fundsonly in assets denominated in national currency, including government securities,deposits with commercial banks and the central bank. To ensure active and flexibleportfolio management, DIF purchases government securities on the primary andsecondary market and conducts repo transactions based on government securities.Maturity of repo agreements and deposits vary from overnight to six months. Theterm of government securities portfolio ranges between three and 36 months, withgovernment securities with a term of up to one year comprising the largest share.Investment management is based on an investment policy, a document approved bythe Management Board. Fulfillment of this document is compulsory for theemployees of the Investment Department. The document describes the principles,goals, strategies and responsibilities of the management body and InvestmentDepartment in respect of investment activity. The investment policy determines thematurity and structure of the investment portfolio, the limits on transactions withmarket participants and responsibilities at various hierarchy levels.Investment policy outlines the compulsory framework of investment activity beingat the same time enough flexible, so that the deposit insurer, acting as a financialinstitution, can take the advantages of particular market conditions. Though notspecified as a priority, investment income is an important indicator monitored by theManagement Board. No profitability parameters are set also because in smallcountries with no bank failures for long periods of time and a significant amount ofaccumulated funds, the market may be deformed to a certain extent. There areseveral big Bulgarian banks called “resource banks” which similar to DIF act mostlyas creditors on the short-term money market: banks due to their wide branchnetwork and a great number of clients, and DIF due to its specific functions. For ashort time DIF strengthened its position both on the money market and governmentInternational Conference on Deposit Insurance Basel, October 22 – 24, 2001
  8. 8. 8securities market. In terms of portfolio amount, DIF ranks seventh among all 35commercial banks operating in Bulgaria.Data on investment activity in some countries suggest that investment portfolios ofdeposit insurers are mostly short-term (up to one year). This exemplifies a primaryfocus on maintaining adequate liquidity. However, the profitability realized fromshort-term transactions is typically lower in a normal yield curve environment. Afinancial problem can be developed because of the compromise between maturityand profitability following the specified requirement for security and liquidity ofinvestment. Such a compromise can be ameliorated in case when the legislationprovides for pledging a portion of the long-term government securities portfolioagainst loans instead of liquidating it. The latter may incur losses under unfavorablemarket conditions. ***It may be concluded that similar to any other issues, investment activity of depositinsurers proves specific in individual countries despite the generally acknowledgedrequirement for security and liquidity of investment under ex-ante systems. Underthe common security and liquidity requirement, specificity of individual countriesreflects the size of the respective country, its foreign exchange regime, the amountof the funds and legal constraints. To this end, studies, discussions and exchange ofinformation on the investment experience of various countries and systems would bevery helpful for deposit insurers.International Conference on Deposit Insurance Basel, October 22 – 24, 2001

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