Informal financial arrangements and the stability of deposit insurance in less developed countries.

• Author: Lein-Lein Chen

1. Introduction

   Deposit insurance first appeared in the State of New York in 1829 to guarantee banknotes and deposits. A number of other states quickly established similar schemes. Some of these schemes were short-lived, as their true cost became known in the panic of 1837, while others were terminated only after the Federal government instituted taxes on banknotes, thereby effectively eliminating all competitors in the currency creation market.(1) After the Knickerbocker Trust panic of 1907, there was renewed interest in deposit insurance, but only limited adoption. The great depression during the 1930s led to the current system, which is mandatory for banks that are members of the Federal Reserve System and voluntary for some state-chartered banks.(2)

   A formalized deposit insurance system like that in the U.S. is found in only a small number of other countries, with varying degrees of coverage and membership requirements.(3) Significant omissions include Panama and Hong Kong, who have large banking sectors in their economies. Accordingly, the role of deposit insurance in the growth of financial intermediaries is fairly ambiguous. One reason that deposit insurance plays a smaller role in developing countries is that they typically suffer from a less diversified economic base, making them more prone to liquidity crises that deposit insurance cannot prevent. Informal financial arrangements, such as savings clubs and rotating credit associations, may be more effective in providing credit than banks or other financial intermediaries, primarily because they do not provide demand deposit accounts and other banking services that may lead to an immediate withdrawal of funds. Informal arrangements often provide for direct renegotiating between borrower and lender. The ability to renegotiate directly with a borrower, not using a bank as an intermediary, provides more liquidity for the lender than a bank offers under similar circumstances because banks must consider the claims of all other depositors as well.

   Recent research suggests that banks and other financial intermediaries evolve to lower the cost of monitoring loans and of converting illiquid into liquid assets [4; 5; 20; 21; 22]. In Diamond and Dybvig's [51 model, deposit insurance may prevent a "bad" equilibrium - bank runs and bank failures - from occurring. In their model, a random event causes a change in expectations about the future value of deposits and produces a bank run, which deposit insurance prevents by fixing the value of deposits to stabilize expectations. In Williamson's [22] model, deposit insurance does not have a stabilizing (or destabilizing) role because bank failures are caused by a particular state of endowments, preferences, and technology. A bank failure is not a "bad" equilibrium caused by random events affecting expectations, but merely an equilibrium that may arise given the model's assumptions.

   The model developed here uses Williamson's [21] generic intermediation model as a starting point and introduces mixed monitoring strategies into the environment. Mixed monitoring strategies permit the intermediary to monitor randomly, somewhat like the U.S. Internal Revenue Service does with the Taxpayer Compliance Program.(4) The alternative is to preconimit to a pure monitoring strategy, in which all borrowers will either be monitored or not monitored. Williamson considers only pure monitoring strategies in his model. It is shown that the strategy of always monitoring is not a Nash equilibrium; that is, intermediaries can improve profits by monitoring project outcomes a little less often.(5)

   Deposit insurance has a role in the model developed here, but it is not likely to arise in less diversified economies where standard banking institutions are expected to be unstable over time; that is, banks in countries with a less diversified economic base are potentially subject to more panics and runs. This model develops conditions under which formal financial intermediaries do not operate in less diversified areas, which gives rise to many informal financial arrangements that make loan payoffs contingent on project outcomes. The model's results are consistent with McKinnon's [13] discussion of financial repression and Shaw's [16] discussion of the lack of financial deepening in less developed countries, except that government policy is not the cause of reduced financial intermediation.

   Informal financial arrangements may take many forms, such as direct lending and rotating credit clubs. This paper discusses rotating credit clubs, because they mobilize deposits as well as make loans and have rules that overcome many of the drawbacks faced by banking institutions. For example, rotating credit clubs specify the holding period for deposits and the frequency of withdrawal by members. By pre-specifying the terms of withdrawal, they immunize themselves against runs and allow for an orderly period of renegotiating in the event of default. Moreover, these clubs often offer a type of deposit insurance to members in that the organizer of the club may guarantee the payment of dues from other members.

   The remainder of this paper is organized as follows. In section II, the arguments for and against deposit insurance are discussed. The question of whether government should have a role in the provision of deposit insurance is addressed. One type of financial arrangement found in informal markets is described and compared to financial contracts found at standard banking institutions. In section III, a model of financial intermediation with overlapping generations is developed. This model shows that random events affecting the value of all loans may make financial intermediaries unstable. An appeal to the law of large numbers to make banks stable, as is done by Diamond [4], Waldo [18], and Williamson [21], does not apply to loans in less developed countries because their economic activity is closely related to only a few primary sectors or commodities, and thus less diversified. Section IV provides some empirical support for the claim that less diversified economies use less financial intermediary services. Finally, section V provides a few concluding remarks and suggestions for future research.

2. Deposit Insurance and informal Lending

   The basic argument in favor of deposit insurance is that it discourages bank runs during periods of unusual demand for liquidity. Banks may operate more efficiently if they can weather these periods without closing their doors, calling loans, and conducting a "fire sale " of assets. On the other hand, guaranteeing deposits encourages risky lending practices, which increases the likelihood of bank runs. Unless the quality of a bank's loan portfolio is restricted and monitored, deposit insurance simply creates a moral hazard problem.

   The need for monitoring is an often cited reason for government to be involved in providing deposit insurance.(6) A government may enforce the penalties imposed on a bank if its officers violate lending or capital constraints, with the ultimate penalties being the removal of officers, forced sale of the bank, or withdrawal of the bank's charter. A private insurer may cancel a bank's insurance if it violates the rules, but this action may create a run on deposits as depositors learn of the bank's insolvency or financial irresponsibility, and this action limits the usefulness of the insurance agreement with depositors. Depositors will realize the tenuous structure of private deposit insurance contracts and quickly discount its value.

   In general, it is difficult for a private insurer to overcome the moral hazard problem. The private insurer is insuring depositors, not shareholders, and thus the incentive for risky lending practices still exists. In bad times, shareholders may find it in their interest to transfer losses to depositors at the expense of the private insurer by simply declaring bankruptcy. Internalizing ownership of the bank and private insurer could solve the moral hazard problem, but on the surface this would not offer meaningful insurance to depositors, who would perceive that their deposits were insured by the bank, and thus not insured at all.

   A solution that is likely to arise in a competitive market is for shareholders to post sufficient collateral to guarantee that they will not act opportunistically with deposits. Depositors will only patronize banks that have offered such guarantees, and thus all banks will offer this implicit insurance. Generally, investments in specific assets, which are assets that have a higher value if the firm is in operation than otherwise, such as advertising and reputation, act as collateral.(7) Thus, it is not always necessary for government...