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

1. BANK FOR INTERNATIONAL SETTLEMENTS
International Conference on Deposit Insurance
Basel, October 22 – 24, 2001
Session 7: Investment Policies for Deposit Insurers
Investment Activity of the Deposit Insurer
Prepared by
Mileti Mladenov
Chairman of the Management Board
Deposit Insurance Fund
Bulgaria

2. 2
Investment Activity of the Deposit Insurer
Investment: Requirements and Constraints
Investment activity is typical of еx-ante systems as well as of combined systems
characterized by preliminary accumulation of funds. To some extent investment is
considered to be of secondary importance and is even underestimated by some ex-
ante systems, consistent with the common legal requirement for security and
liquidity of accumulated funds. Security and liquidity of funds proves a top priority,
and therefore income on invested funds occupies a subordinate place. This view may
be reasonable for big countries with a stable national currency that is used as an
international payment instrument. In such countries deposits that are subject to
insurance are denominated mostly in national currency.
However, the situation in small countries with closed and unconvertible currencies is
different. In these countries individuals and companies hold a portion of their
savings in national currency deposits and a significant portion in convertible foreign
currency. This results in foreign exchange risk for the respective component of
deposits protected by the deposit insurer. Such countries are characterized by
specificity associated with the exchange rate regime, distribution of deposits in
national and foreign currency, deposit insurer’s risk evaluation, etc.
Let me formulate the following hypothesis: despite the security and liquidity
priority, a deposit insurer under an ex-ante system should make efforts to manage
accumulated funds as well as the insured bank would, if these funds had been left in
the bank’s own portfolio. As such, investment income would be maximized while
still observing security and liquidity requirements. Practically, this is hard to be
achieved but it exists as an implicit requirement, which, I suppose has been realized
by management bodies and managers of deposit insurance schemes.
Commonly, investment options are legally formulated leaving little room for
maneuvers of the deposit insurer. The status of the deposit insurer as a financial
institution is not always explicitly defined by law, although it actually acts as such
International Conference on Deposit Insurance Basel, October 22 – 24, 2001

3. 3
institution. 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 a
quasi-bank or quasi-financial institution as it has to participate almost every day on
the market or, if it uses an agent, to constantly monitor the market.
Investment alternatives and solutions are also impacted by the amount of premiums
and investable funds. Internationally, there is a trend towards reducing or even
eliminating required reserves. However, there are a number of reasons to keep
significant required reserves in many countries. It must not be ignored that deposit
insurance premiums together with required reserves constitute a financial burden for
banks. This can result in a distorted interest rate structure and finally, the burden is
ultimately born by bank customers. Some participant banks in the deposit insurance
system express an informal discontent both against the heavy cost of insurance
premiums as well as the amount of income generated through the management of
the insurance fund, despite the fact that participant banks are not the owners of these
funds from legal point of view.
Comparatively low concern in respect of investment and realized income is
associated also with privileges provided for some deposit insurance schemes, e.g.
direct access to government securities primary market (if the deposit insurer is
authorized to act as a primary dealer), off-market formation of the investment
portfolio by direct purchases of government securities from the Ministry of Finance,
etc. This coupled with a sound convertible national currency makes the status of
corresponding national institutions quite different, from the status of identical
institutions in smaller countries. Therefore, the issue of investment and investment
policy of deposit insurers will further stay in the focus of interest for particular
countries. Although this concerns ex-ante systems which are expected to dominate
in the future, investment policy is unlikely to be standardized, and deposit insurer’s
management bodies will have greater freedom in designing their investment
policies. Concurrently, the general principle for security and liquidity of funds will
sustain its priority, as periods of calmness and lack of bank bankruptcies will be
unavoidably followed by periods of increasing rates of bank closures.
International Conference on Deposit Insurance Basel, October 22 – 24, 2001

4. 4
Sustaining the value of accumulated funds is of significant importance for countries
with closed, unconvertible currencies. This issue may be considered in two aspects:
preserving internal purchasing power and sustaining the value of funds measured in
stable foreign currencies.
To avoid erosion of funds, investment income should not lag behind the inflation
rate or any other index measuring the internal purchasing power. In practice, this
proves impossible to be achieved at any time, since the level of internal interest
rates, and particularly, the yield of government securities as a major financial
instrument may be lower than the inflation rate. Real interest rates are very dynamic
and sometimes unpredictable in smaller countries with unstable economies and
underdeveloped financial markets.
Preserving external purchasing power of the accumulated funds depends on two
factors: the exchange rate of the national currency and international interest rates. A
ban on investment in foreign currency-denominated assets may have an additional
adverse effect since the deposit insurer is completely exposed to foreign exchange
risk associated with a possible national currency devaluation against the foreign
currencies in which a significant portion of deposits is held.
In general the deposit insurer’s portfolio includes risk-free and low risk assets with
short 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 covering
administrative expenses of the deposit insurer. This alternative was discussed in
several countries but no information on its practical application is available.
Very often deposit insurers manage their investment portfolios indirectly by
concluding agreements with a bank or other institution - a financial intermediary, on
formation, maintenance, and management of their investment portfolio. In this case
overhead expenses of the investing institution decrease. The agent receives a
commission or other remuneration. Consequently, it should be decided which of the
two opportunities is financially more favorable. Undoubtedly, the issue of agent’s
risk remains. The degree of risk is different in countries with a stable economy and
International Conference on Deposit Insurance Basel, October 22 – 24, 2001

5. 5
developed financial system and in emerging market economies with unsound
financial systems. However, even in the second group of countries there are
sufficient modern financial tools providing opportunities for eliminating or
minimizing the agent’s risk.
Deposit insurer’s investment activity depends to a certain extent on the amount of
available funds. In principle, the bigger fund provides better opportunities for
constituting and managing the portfolio, e.g. in respect of portfolio’s maturity
structure and profitability. This concerns the more general question of the fund’s
optimal amount under ex-ante systems. The specificity of each country determines
the structure, activity and constraints in deposit insurance. Adoption of the rule of
thumb that the minimum amount of funds should be sufficient to cover the risk in
the biggest among medium-size banks and lower than the risk degree in big banks
appears to be reasonable. Legislation of individual countries provides for a different
amount of funds, and in general, the prescribed amount reflects the assessment of
legislators, policy makers, experts and the public on the stability and general risk for
the banking system.
From institutional point of view, deposit insurer’s investment is usually managed on
the basis of an investment policy, approved by the management body of the
institution. The investment policy includes principles, goals, strategies, and
important internal controls. The investment function can be managed by a special
department within the institution or by an agent. In the second case the deposit
insurer receives only information about the state of the portfolio and controls the
compliance with agreed terms and constraints. Investment policy design is an
important component in management under ex-ante systems. This document should
be of utmost clarity and precision, being at the same time flexible enough to allow
using the market opportunities under the inevitably changing market conditions. In
this respect, this document is similar to internal documents regulating operations of
bank and nonbank financial institutions.
International Conference on Deposit Insurance Basel, October 22 – 24, 2001

6. 6
Investment Activity of the Deposit Insurance Fund of Bulgaria
The first deposit insurance scheme in Bulgaria was established in early 1996. This
deposit insurance scheme was based on Directive 94/19/EC of 1994. Actually, the
deposit insurance scheme failed to start normal operations due to the outbreak of the
dire 1996 financial crisis when 15 banks, comprising more than 25% of the banking
system assets failed. To curb the crisis, extraordinary legislation was adopted,
providing for a 100% repayment of the deposits of individuals and a 50% repayment
of the deposits of companies in closed banks from the budget. The Deposit
Insurance 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 partial
cover of deposits. The operating deposit insurance system is of ex-ante type with
banks paying annual premiums equivalent to 0.5% of the deposit base (deposits of
individuals and companies). In case of a bank failure DIF starts repaying insured
deposits not later than 45 days after a bank has been declared bankrupt. By 1
October 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 current
exchange rate. Entry and premium contributions are paid by banks in national
currency. Accumulated funds are also invested only in national currency. This
causes foreign exchange risk for the portion of funds corresponding to the foreign
exchange component of the deposit base. By mid-2001 the share of insured foreign
deposits was 56%. Seventy percent of foreign currency deposits are denominated in
US 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 and
the German mark was initially set as a reserve currency and later replaced by the
Euro, there is no risk for the portion of foreign currency deposits denominated in
Euro (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 initiated
amendments to the effective legislation intended to remove foreign exchange risk
(the amendments have not come in force yet). The amendments provide for payment
of the portion of premiums on foreign currency deposits in the respective foreign
currency and accumulated funds in foreign currency to be invested in assets
International Conference on Deposit Insurance Basel, October 22 – 24, 2001

7. 7
denominated in the corresponding currency. The portfolio should be periodically
restructured in order to sustain the correspondence with insured deposits. Binding
foreign currency premiums with foreign currency assets is also reasonable with a
view to avoiding open positions, and correspondingly foreign exchange risk
associated with them.
In accordance with currently effective legislation DIF invests accumulated funds
only in assets denominated in national currency, including government securities,
deposits with commercial banks and the central bank. To ensure active and flexible
portfolio management, DIF purchases government securities on the primary and
secondary market and conducts repo transactions based on government securities.
Maturity of repo agreements and deposits vary from overnight to six months. The
term of government securities portfolio ranges between three and 36 months, with
government securities with a term of up to one year comprising the largest share.
Investment management is based on an investment policy, a document approved by
the Management Board. Fulfillment of this document is compulsory for the
employees of the Investment Department. The document describes the principles,
goals, strategies and responsibilities of the management body and Investment
Department in respect of investment activity. The investment policy determines the
maturity and structure of the investment portfolio, the limits on transactions with
market participants and responsibilities at various hierarchy levels.
Investment policy outlines the compulsory framework of investment activity being
at the same time enough flexible, so that the deposit insurer, acting as a financial
institution, can take the advantages of particular market conditions. Though not
specified as a priority, investment income is an important indicator monitored by the
Management Board. No profitability parameters are set also because in small
countries with no bank failures for long periods of time and a significant amount of
accumulated funds, the market may be deformed to a certain extent. There are
several big Bulgarian banks called “resource banks” which similar to DIF act mostly
as creditors on the short-term money market: banks due to their wide branch
network and a great number of clients, and DIF due to its specific functions. For a
short time DIF strengthened its position both on the money market and government
International Conference on Deposit Insurance Basel, October 22 – 24, 2001

8. 8
securities market. In terms of portfolio amount, DIF ranks seventh among all 35
commercial banks operating in Bulgaria.
Data on investment activity in some countries suggest that investment portfolios of
deposit insurers are mostly short-term (up to one year). This exemplifies a primary
focus on maintaining adequate liquidity. However, the profitability realized from
short-term transactions is typically lower in a normal yield curve environment. A
financial problem can be developed because of the compromise between maturity
and profitability following the specified requirement for security and liquidity of
investment. Such a compromise can be ameliorated in case when the legislation
provides for pledging a portion of the long-term government securities portfolio
against loans instead of liquidating it. The latter may incur losses under unfavorable
market conditions.
***
It may be concluded that similar to any other issues, investment activity of deposit
insurers proves specific in individual countries despite the generally acknowledged
requirement for security and liquidity of investment under ex-ante systems. Under
the common security and liquidity requirement, specificity of individual countries
reflects the size of the respective country, its foreign exchange regime, the amount
of the funds and legal constraints. To this end, studies, discussions and exchange of
information on the investment experience of various countries and systems would be
very helpful for deposit insurers.
International Conference on Deposit Insurance Basel, October 22 – 24, 2001