Evaluation of Deposit Insurance Fund Adequacy Using Credit Risk Model—An Indian Experience

Abstract

There are two methods widely used for evaluating the adequacy of Deposit Insurance Fund: (i) Target Reserve Ratio and (ii) Credit Risk Model. Target Reserve Ratio is one of the macro level indicators more often set by Regulatory act on the basis of minimum Deposit Insurance Fund margin safety. Target Reserve Ratio is calculated as the ratio of Deposit Insurance Fund to the value of insured deposits. However, TRR does not take into consideration the level of Deposit Insurance potential liability, the Loss at Given Default (LGD) and the historical trend of default rate prevailing among the insured banks. It does not also consider the present condition of the economy and current scenario of the banking sector. This paper discusses primarily about development of Credit Risk Model for evaluating the Deposit Insurance Fund Adequacy. For this purpose, Econometric Credit Risk Model was developed based on the historical data of bank failures and the associated losses of the last 25 years from 1990-91 to 2014-15. The model assesses various possible factors impacting the Deposit Insurance Fund: Default rate, Deposit growth, Exposures, impact of macroeconomic factors like GDP, GDS, Inflation and Interest rate changes, etc. on the Deposit Insurance Fund through econometric modeling. The model evaluates the adequacy of Deposit Insurance Fund under both (i) Normal scenarios where there is no (economic) systemic risk assumed and (ii) Worst case scenario at 1% level of significance using Monte Carlo Simulation. Since the model empirically validates all the critical factors impacting the assets and liabilities associated with Loss at Given Default, the model output can also be used to determine a suitable Target Reserve Ratio and such models are being used in countries like USA, Canada, Hong Kong, and Singapore, etc. (IADI, 2009). More importantly, the model outputs are quite useful in determining the adequacy of deposit insurance fund which is an effective risk control measure that organization like Deposit Insurance Credit Guarantee Corporation (DICGC) can adopt both under normal economic scenario as well as worst case scenario, ensuring a strong financial safety net for the banking sector in India. The model also assesses the default probability and the Loss at Given Default of different types of banks: commercial banks, rural banks, cooperative banks, foreign banks, etc. A risk based on premium can possibly be determined for each type of banks in India.