1.1 Deposit Insurance Funding
Sound funding arrangements are critical for the effectiveness of a deposit insurance system. According to the Financial Stability Forum (FSF) Working Group on Deposit Insurance (2001), a deposit insurance system should have available all funding mechanisms necessary to ensure prompt reimbursement of depositors’ claims. For most deposit insurance schemes worldwide, premium contribution by insured institutions constitutes the major source of funding.
1.2 Deposit Insurance Premium Assessment
Deposit Insurers collecting premiums from member financial institutions which accept deposits from the public (hereafter referred to as banks) usually choose between adopting a flat-rate premium or a system that seeks to differentiate premiums on the basis of individual-bank risk profiles. A Flat-rate premium system has the advantage of being relatively easy to understand and administer. Also, it allows the strong banks to subsidize the weak ones for the stability of the financial system. However, it does not take into account the level of risk that a bank poses to the deposit insurance system, and can therefore be perceived as unfair in that the same premium rate is charged to all banks regardless of their degrees of risk. The implementation of a differential premium assessment system poses numerous challenges in spite of its seeming fairness. Some of these challenges include: finding appropriate and acceptable methods of differentiating banks by risks; obtaining reliable, consistent and timely information for risk differentiation, and ensuring that rating criteria are transparent.
1.3 Differential Premium Assessment System (DPAS)
Primarily for the above reasons, differential premium assessment systems are being canvassed in recent years. A DPAS is an attempt to classify banks into various risk buckets and apply different premium rates depending on the perceived riskiness of each risk bucket.
The first recorded differential premium assessment system was introduced by the United States Federal Deposit Insurance Corporation (FDIC) in 1993. Since that time, the number of deposit insurance schemes (DIS) adopting DPAS has grown and it was estimated that there were around twenty-five countries that are either implementing or in the process of introducing the DPAS as at March 2007 out of about 119 deposit insurance agencies worldwide. Apart from Nigeria, no other country in Africa has initiated the process of introducing the differential premium assessment system.
1.4 Adoption of Differential Premium Assessment in Nigeria
With the emergence of bigger banks post-consolidation, sound risk management becomes one of the key factors in ensuring the safety and soundness of the banking system. Given the on-going initiative to adopt a risk-based supervisory framework and the emphasis placed on risk management by the Basle II Capital Accord, the Corporation has deemed it imperative to transit from the flat rate premium assessment system to a differential premium system. Furthermore, the NDIC Act No. 16 of 2006 has given the Corporation the power and flexibility to vary the rate, the assessment base as well as the method of premium assessment. It is against this background that the Corporation has deemed it appropriate and timely to develop a framework for DPAS.
2.0 THE PRACTICE OF DPAS IN SOME JURISDICTIONS
2.1 In virtually all jurisdictions, the starting point for deposit insurance system pricing is the flat rate approach before migration to the differential premium assessment approach mainly because of the complexity in implementing the latter. For instance, it took the Federal Deposit Insurance Corporation (FDIC) of the United States of America, which was established in 1933, sixty (60) years before it introduced DPAS while it took the Canada Deposit Insurance Corporation (CDIC) thirty-two (32) years before migrating to DPAS from the flat rate approach.
2.2 Evidence from countries currently adopting the differential premium assessment system shows the preference for a combination of both quantitative and qualitative factors. Nonetheless, the tendency has been to give more weight to quantitative elements than qualitative factors. All DPAS models are virtually the same in that they all have base premium rates for banks in the best (lowest) risk category and with escalated premium rates for banks in higher risk classes. The only major difference however, is that some DPAS models have predetermined number of risk/premium categories whilst others do not.
3.0 ISSUES FOR CONSIDERATION WHILE DESIGNING AND IMPLEMENTING DPAS
3.1 One of the necessary conditions for a successful implementation of a differential premium regime is ensuring that information to be used for risk classification are readily available. The information equally should be timely, consistent and reliable. Furthermore, the deposit insurer should be able to validate the integrity of such information from time to time. In the main, great attention should be paid to data integrity in order to ensure effective implementation of a DPAS. In this regard, NDIC has noted with concern the significant reduction in the deposit liabilities of some banks at year ends.
3.2 Another factor to consider for a successful implementation of a differential premium system is categorization of banks into different risk buckets. The process of risk differentiation and eventual categorization of banks into risk buckets should not be too complex. Stakeholders especially the insured banks that pay the premiums should be able to verify its risk class categorization.
3.3 In an effort to assure transparency, accountability, market discipline and sound management through public disclosure, the deposit insurer should be careful about what to disclose about insured institutions, so that competitors would not use disclosed information to achieve competitive edge or exacerbate a bad situation. In that regard, each bank would be given only its own risk categorization and applicable premium rate.
3.4 Finally, in order to ensure the sustainability of the system, a differential deposit insurance regime needs to be constantly reviewed, up-dated and fine-tuned. Such reviews can result from experiences garnered over time or through scenario testing. Again, reviews can be necessitated by structural changes in the industry, changes in reporting requirements and/or changes in approaches to supervision.
4.0 OBJECTIVES OF THE FRAMEWORK
The overall objective of the framework is to promote sound risk management in insured institutions without jeopardizing the deposit insurance fund by differentiating premiums paid by insured institutions on the basis of their risk profiles.
5.0 METHODOLOGY OF THE FRAMEWORK
The methodology applied to achieve the above objectives is a combination of the lessons learnt from the approaches adopted by other jurisdictions and our lessons of experience in implementing the deposit insurance scheme in Nigeria. These led to the development of the proposed framework based on both quantitative and qualitative factors. The adoption of the methodology will entail the following two primary stages:
i. The determination of a base premium Rate Ro for banks in the best (lowest) risk category.
ii. The determination of add-ons based on the individual bank’s risk profile using both quantitative and qualitative factors.
6.0 APPLICATION OF THE FRAMEWORK METHODOLOGY
Differential Premium Rate Matrix for the Determination of Add-ons based on Individual Bank Risk Profiles
|Basic Premium Rate||(Ro)%|
(a) Capital to Risk Weighted Assets Ratio
(b) Adjusted Capital to Net Credit Ratio
X < 5
5 ≤ X < 8
8 ≤ X < 10
X > 1: 10
(a) Non performing Credits to Total Credits Ratio
(b) Violation of Aggregate insider lending: (all insiders & related party interest)
(c) Non Performing Insider Credits
(d) Violation of single obligor limit
X ≥ 20
15 ≤ X < 20
10 ≤ X < 15
X > 60% of paid up capital
X > 0
Credits > 20% of shareholders’ funds:
(a) Liquidity Ratio
X < 15
15 ≤ X < 20
20 ≤ X < 25
|Qualitative Factors (Mgt)|
Poor Internal Control
|5||Late Rendition of Returns||0.01|
|7||Poor Risk Management System||0.02|
|8||Non implementation of examiners’ Recommendations||0.02|
|Total Add on Premium Points ≤ 30||0.30|
|PREMIUM RATE (Ro+Total Add-ons)||Ro+0.30|
* For all the quantitative factors, prudential/regulatory stipulated thresholds have been used as the benchmarks.
7.1 The Flat-rate Premium System is relatively simple to understand and administer. DPAS ensures fair pricing but is more complex, hence the greater need for more timely, accurate and reliable information from insured institutions. The proposed model attempts to classify banks into various risk buckets and apply different premium rates depending on the perceived riskiness of each bank.
7.2 The DPAS models practised in various countries show the preference for a combination of both quantitative and qualitative factors, with a tendency to give greater weight to quantitative than qualitative factors. All DPAS models are virtually the same because they all basically have base premium rates for banks in the best (lowest) risk category with escalated rates for riskier banks. The only major difference is that while some have predetermined number of risk/premium rate categories others do not.
7.3 The Framework has been developed to encourage sound risk management and hence, reduction in premium payable by banks.