Deposit insurance is a pre-payment of the insured account balance held at a supervised credit institutions prior to the failure of a bank or credit institution. The intent of deposit insurance is to provide liquidity to retail customers and support the real economy. Simultaneously, the resolution authority remains in a position to draft a cost-efficient and effective recovery and resolution plan so that stakeholder interest is protected.
The structure of a deposit guarantee scheme (DGS) contains similarities with traditional insurance policies but are distinct in several ways. Therefore the term deposit insurance does not quite cover its underlying scope and meaning. A deposit guarantee scheme repays bank deposits to eligible account holders of a supervised financial institution. Contrary to traditional insurance, the scheme has premium paying participants that cover only the eligible account balances held with other members of the same scheme in the event of default of the member.
Bank account holders who are eligible for deposit protection are covered for their insured balance. This maximized balance is based on local requirements. Many international financial centers with large amounts of foreign capital on their balance sheets do not wish to burden or levy local account holders, whose income is often lower than their international counterparts. It is therefore customary to have limitations on for example currency, business activities or amounts covered.
Most Deposit Guarantee Schemes have similarities with insurance policies. The structure, scope and internal framework of such schemes however contain crucial differences. Above all, a DGS scheme is limited by local laws and international directives. It is managed by member institutions that are responsible to cover losses by its members, and also excludes certain bank account balances from coverage. Rules are expressed in advance and scheme participants and covered creditors can read the terms and act accordingly prior to the failure of their bank. Another important distinction between a DGS scheme and traditional insurance is that by honoring a DGS payment, the insured and repaid claim by the creditor is transferred to the DGS fund so that the fund can recover its prepayment.
Conflict of laws exist in cross border insolvency settings where distinct legal systems govern the liquidation procedures. In most jurisdictions, the award of a DGS claim transfers the ownership of the insured account balance to the DGS fund. The DGS fund therewith retains a position in the liquidation procedures. Account holders with balances that exceed the insured limits, whose claim is rejected or who are eligible or disqualified for coverage remain to hold a claim against the assets of the bank. The DGS fund however may be stuck in the middle and dependent on a position in the insolvency hierarchy of the jurisdiction responsible for the liquidation procedures. In home states, the DGS fund often holds a priority position in these liquidation procedures, while host states often do not recognize such a position and subordinate the claim of a foreign DGS fund in creditor their respective hierarchy. The activation of a Deposit Guarantee Scheme in matters of cross-border bank failures is therefore difficult and may take some extra time.