Deposit Protection Corporation

Stability of their financial systems is of paramount concern for policymakers around the world. Every country endeavors to develop and put in place tools and mechanisms to protect its financial system from various kinds of endogenous and exogenous shocks. These tools and mechanisms collectively form the regulatory architecture; the foundation stone on which banks and other financial institutions flourish.     State Bank of Pakistan (SBP) has established a comprehensive framework to ensure safety and soundness of the banking system of Pakistan. While the key pillars of this framework, namely strong banking laws and regulations, and effective supervision have been in place for a long time, the introduction of Deposit Protection is a more recent initiative. Having a formal deposit protection (aka deposit insurance) scheme is considered a vital element of financial safety nets. Globally, the number of countries with deposit protection schemes has grown from only 12 in 1974 to 126 (including Pakistan) as of June 2017.

The financial crisis of 2008 has increased the focus on deposit protection. A number of countries made improvements in their pre-existing frameworks in view of the lessons learnt from the recent financial crisis. Consequently, deposit protection has become a requisite for financial stability. Further, financial sector assessment of a country by Multilateral Agencies is positively impacted if an effective formal deposit protection exists.

Rationale for Deposit Protection Scheme (DPS)

The deposit protection schemes are designed to deal with failure of a bank on standalone basis and reduce the likelihood of conversion of individual bank failure into contagion and systemic problems.

A formal depositor protection offers wide ranging benefits including, but not limited to,: (1)- contribute towards a stable financial system by minimizing the possibility of bank runs; (2)- protect small and financially unsophisticated depositors from the loss of their deposits; (3)- allocate funds to provide immediate liquidity to depositors in case of bank failures; (4)- limit use of tax payers’ money for bank failures, as the funds providing such protection are raised from the industry ex-ante; and (5)- provide a streamline mechanism for payments to depositors and thus facilitate bank resolution actions of supervisors.

The banking system in Pakistan has become increasingly private sector-owned; initially through privatization of the once dominant state-owned banks, and subsequently with the entry of new banks. Consequently, the share of public sector banks in the total assets of banks has dropped from 92% in 1990 to around 19% in December 2016. With widening outreach of banking facilities to the rural and remote areas of the country, large numbers of small and unsophisticated depositors have been brought into the banking system.

The supervisory regime of SBP is robust enough to safeguard against significant financial risks in the banking system, and it is aptly complemented by sufficient legal powers to resolve any financially weak bank. This supervisory and legal framework has historically helped SBP to avoid financial crises or losses to depositors.

Establishment of a formal DPS will be beneficial for Pakistan because it will build up sizable funds, through premium payments from banks that can be used to provide immediate liquidity to small depositors in the unlikely case of a bank failure. This will also reduce burden on taxpayers because if such funds do not exist, then either the depositors will lose money or government has to provide taxpayers’ funds to bail them out.

Formation and Establishment of Deposit Protection Corporation (DPC)

The establishment of DPC was envisaged as one of the important objectives in SBP’s strategic plan 2016-2020 under the strategic goal of “strengthen the financial system stability regime”. DPC was established as a wholly owned subsidiary of SBP under the Deposit Protection Corporation Act, 2016. The objective of DPC is to compensate the depositors to the extent of protected deposits in the event of a bank failure. The limit of protected deposits has been determined to be at Rs250,000 per depositor per bank by DPC and has been rolled out along with related instructions.

Even prior to promulgation of the Act, State Bank had been working on designing a deposit protection mechanism for Pakistan’s banking sector. Since promulgation, besides in-house deliberations, consultations on main features of the deposit protection were carried out with banks, multilateral agencies and deposit protection agencies of other countries.

The international standard followed for designing a robust deposit protection scheme is given in “Core Principles for Effective Deposit Insurance Systems” issued by International Association of Deposit Insurers (IADI) originally issued in 2009 and updated in 2014.  The design features of DPC in Pakistan are quite congruent with these principles. It is important to ensure that the design does not encourage moral hazard or excessive risk taking by banks or institutional depositors. Hence, most schemes cover smaller unsophisticated depositors rather than the entire deposit stock.  Generally, the level of protected deposit coverage is between 1 to 2 times of GDP per capita. In Pakistan, the protected deposit coverage is set at Rs250,000/- per depositor per bank, which translates into 1.39 times of GDP per capital.

Moreover, in order to have a level playing field, all commercial banks will be members of DPC and will be liable to pay the prescribed premium. For the purpose of protecting depositors of Islamic Banks, a separate Shariah compliant mechanism of deposit protection will be put in place as envisaged in the Act.

It can be said that the right time to introduce a deposit protection mechanism is when majority of the system is stable, with sound capital adequacy coupled with reasonable profitability and growth. Pakistan’s banking system currently enjoys CAR of 15.8% as of Dec-17, and its deposits have been enjoying an average growth of around 12% during last five years, while its return on equity has been in the range of 24.3% to 19.5% from 2014 to 2017. It is therefore essential to introduce and build up deposit protection funding arrangements in these years, so that in future if any bank goes in crisis, the system is well prepared to absorb the shock. The implementation of deposit protection will strengthen the risk profile of the banking industry which would enhance trust of general public in our system.