Investment Activity of the Deposit Insurer

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

International Conference on Deposit Insurance Basel, October 22 – 24, 2001

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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


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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.


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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


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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.


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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


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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


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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.

Economy & Finance

Investment Activity of the Deposit Insurer