This started around the time the Icelandic banks collapsed and Icesave was in the headlines. Then it died off and didn’t resurface until the Eurozone crisis. Now it’s one of the hippest phrases in offshore financing.
In this post I will go through what it is, why it probably doesn’t work the way you think, and why I think that deposit insurance fixation is unhealthy.
What is Deposit Insurance?
Deposit insurance is an insurance that the money you put in a bank will be safe in case of a bank collapsing. There is usually a limit to the insurance. Across the EU, for example, the norm is 100,000 EUR or currency equivalent.
The insurance is usually limited per person per bank, meaning you can enjoy greater insurance by banking with multiple banks.
In some cases, such as Singapore, the deposit insurance is limited to the local currency.
Varyingly, non-banking financial institutions may also be subject to deposit insurance; either the same as banks or a different kind. Check with the authorities in your relevant jurisdictions.
How Deposit Insurance Works
The way it’s supposed to work varies somewhat but is ultimately similar.
One way is that the government of the country where the failing bank is in automatically pays out to all account holders of the bank. This means the bank (what’s left of it) hands over all records of its customers to the government and the government then makes payments or contacts the account holders. The handing over of records shouldn’t be a breach of banking secrecy, but since it’s untested in almost every jurisdiction it’s not entirel clear.
Another way it would work is account holders would have to approach the government or a government authority – typically the central bank – to claim their insurance back. The government will then match your claim against the bank’s records, usually on a case-by-case basis.
Problems with Deposit Insurance
Icesave and, later, Cyprus have shown us that deposit insurance may not work as intended. Iceland refused to pay out and Cyprus tried to get around the deposit insurance by applying a one-off tax.
As briefly touched on in the post titled How and Where to Start an Offshore Bank, it’s important to understand that many offshore banks operate in a bit of a separate banking system, called International Banking. These are banks which are licensed under International Banking Acts (IBAs) and do not accept domestic or even regional customers.
Funds held with IBA banks are of no importance to the local government other than tiny tax revenue and reputation.
In case a bank collapses, the only incentive for the government to pay out deposit insurance – if one exists and is applicable to international banks – is reputational. If finances are tight, it is safe to assume that the government will focus on its local residents over foreign investors who contribute nothing to the local economy.
Slow and Untested
Paying out deposit insurance can be a very slow process. In addition to being a large administrative undertaking, the government can’t always afford to pay it out deposit insurance and may be forced to take out loans, which can cause further delays. See for example a 264 million EUR loan the Latvian government had to take to afford the deposit insurance for Latvijas Krājbanka.
While it is a good thing that few banks have failed, it means that the legalities surrounding deposit insurances are untested. It’s usually cheaper and looks better to save banks than to let them fail and have to pay out insurance.
Deposit Insurance Fixation
For the aforementioned reasons, deposit insurance probably may not be as great as you think it is.
It is often obsessed about, to the point of ruling out banks and jurisdictions that although not insured may be more financially sound than an insured bank and jurisdiction.
While there is nothing wrong or bad about spreading your assets so that parts are covered by deposit insurances, using exclusively banks with a deposit insurance will rule out a lot of banks, some of which are more stable than many insured banks.