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A Methodology for Determining the Target Fund

Level of a Deposit Insurer

Camilo Hernández LópezHead of Risk Department

Fogafín

Abstract

• The aim of this presentation is to offer a technical way to set a target for the funding level of the deposit insurer agency (the methodology is based on the deposit insurer’s loss distribution function and its risk tolerance).

• After setting the target level, we propose a methodology to define how to finance it: how much should come from premiums and how much from other sources.

Agenda

1. Introduction

2. How Fogafín dealt with the financing of the last financial crisis

3. Colombian case

4. Future challenges

5. Final remarks

3

1. Introduction

• Fogafín’s funds come from premiums charged to financial institutions • Financial institutions pay 0.3% of deposits +/- 50% depending on their risk• The current funds are approximately 3.5% of insurable deposits: preliminary

analysis that we have done point to 5.5% as a desirable target level

Fogafín (Colombia’s DIA for financial institutions) was created in 1985, following animportant financial crisis that forced the government to nationalize a significantpart of the financial system, with two main purposes:

• Provide capital support for financial institutions without unduly benefitingshareholders, administrators or those responsible for the difficulties.

• Organize a deposit insurance scheme.

Fogafín’s role is not limited to non-systemic events and funding and investmentpolicies take this into account

Agenda

1. Introduction

2. How Fogafín dealt with the financing of the last financial crisis

3. Colombian Case

4. Future challenges

5. Final remarks

5

2. How Fogafín dealt with the funding of the last financial crisis

6

Fund size as percentage of total eligible deposits

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Deposit Insurance Fund

Deposit Insurance Fund - Borrowing

Deposit Insurance Fund - Borrowing and bonds

Resources of the deposit insurance fund were insufficient to cover the costs associated with the bankruptcy of member financial institutions.

7

Deposit Insurance Premium(1995 - 2012)

0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

Source: Fogafin y SFC

2. How Fogafín dealt with the funding of the last financial crisis

Agenda

1. Introduction

2. How Fogafín dealt with the financing of the last financial crisis

3. Colombian case

4. Future challenges

5. Final remarks

8

3. Colombian Case – Timeline

2011

- Historical analysis.

2012

- Statistical methodology

- Funding scheme

2013

- Flexibility in premium scheme

2014

- Other funds sources

10

• The DIF as a proportion of the eligible deposits had been falling from a high of4.07% in 2009.

Eligible Deposits Growth and DIF Growth– DIF as a Proportion of the Eligible Deposits

3.1%

15.8%

13.9%

2.5%

3.0%

3.5%

4.0%

4.5%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

dic

.-0

9

mar

.-1

0

jun

.-1

0

sep

.-1

0

dic

.-1

0

mar

.-11

jun

.-1

1

sep

.-1

1

dic

.-1

1

mar

.-1

2

jun

.-1

2

sep

.-1

2

dic

.-1

2

mar

.-1

3

jun

.-1

3

sep

.-1

3

dic

.-1

3

mar

.-1

4

DIF as a proportion of the eligible depositsDIF annual growthEligible deposits annual growth

DIF / Insurable deposits

Historical analysis

11

Available funds and (not probable) needs today similar to end of 1990´s (Methodology based on historical analysis)

3.3%

5.1%

0%

2%

4%

6%

dic

-08

jun

-09

dic

-09

jun

-10

dic

-10

jun

-11

dic

-11

jun

-12

dic

-12

jun

-13

dic

-13

jun

-14

dic

-14

jun

-15

dic

-15

Deposit insurance fund as a proportion of the eligible deposits

Scenario of financial crisis (similar to the 90´s) adjusted to today´s characteristics

FDIC (2010). Toward a Long-Term Strategy for Deposit Insurance Fund Management

https://www.fdic.gov/bank/analytical/quarterly/2010_vol4_4/FDIC_Quarterly_v4n4_FundMgmt_121610.pdf

3. Colombian Case – Timeline

2011

- Historical analysis.

- Analysis of theratio (Reserve /

Insurable deposits)

2012

- Statistical methodology

- Funding scheme

2013

- Flexibility in premium scheme

2014

- Other funds sources

Statistical methodology

We follow the statistical methodology proposed in "Evaluation of Deposit Insurance Fund Sufficiency on the Basis of Risk Analysis" (IADI – 2011).

1. Deposit insurer’s loss distribution function

2. Risk tolerance of the DIA

3. Ex-ante funding and other funding mechanism

Serna (2013). A Methodology for Determining the Target Funding Level of a Deposit Insurer https://www.fogafin.gov.co/default/imagenes/file/Informacion%20al%20Ciudadano/Publicaciones/Funding%20target%20level.pdf

The loss distribution function

14

1. Calculate the DIA’s financial exposure to each institution

Insured deposits

for each bank.

2. Calculate the probabilities of default (PD) for each bank and correlations between them:

The PD were associated

to periods of financial stress

• Using a Probit, we calculate the probability for each bank to have a CAMEL rating of 1, 2, 3, 4 or 5 in a period of t+12 months.

• We define Default as a CAMEL score lower than 1.5.

How to measure the PD and the correlations

15

Insured Banks’ PD

Simulation process and built up the loss distribution function

16

• We assume that each time that anevent of bankruptcy occurs, the DIApays an amount equivalent of itsexposure to the troubled institution.

• We repeat a significant number oftimes the whole process to get a flowof payments equal to the number oftrials. The result of this process is theloss distribution function of the DIA.

DIS exposure to the event

of bankruptcy of the

entities (millions)

Number of

occurrences

(frequency)

Probability of

occurrence of

the event

0.0 19,346 96.73%

1.0 111 0.56%

2.0 7 0.04%

3.0 0 0.00%

4.0 14 0.07%

5.0 9 0.05%

6.0 4 0.02%

7.0 0 0.00%

8.0 0 0.00%

9.0 5 0.03%

10.0 25 0.13%

11.0 12 0.06%

12.0 6 0.03%

13.0 11 0.06%

14.0 14 0.07%

15.0 23 0.12%

16.0 41 0.21%

17.0 48 0.24%

18.0 0 0.00%

19.0 5 0.03%

20.0 319 1.60%

Total 20,000 100.00%

Determining the risk tolerance

The idea is that the DIA should be stronger than any of its insured members (Bennett, 2001):

• Thus, the acceptable level of risk must be associated with the lowest PD of the insured institutions

The PD is linked to a given percentile of the loss distribution function.

Final step: the size of the fund (it will be the one that covers payments at the level of chosen risk)

• The percentile 99 corresponds to a target fund of A

• With a 99% probability (or 1% PD), a fund of the size of A covers the DIA’ required payments in a year.

17

0%

1%

2%

3%

4%

5%

6%

7%

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80

Pe

rce

nti

les

Exposition $

A

X'

Right tail of the loss distribution function

Splitting ex-ante funding in two

18

• Resources collected throughpremiums should be enough to coverthe proportion of resources that arenot expected to be recovered from theliquidation process of the insuredinstitution

• The proportion of resources that areexpected to be recovered can befinanced with alternatives sourcessuch as contingency credit lines.

Ex-ante Funding and alternative sources

75.0%

25.0% Premiums collection = (LGD)

Alternatives sources = (1-LGD)

Investment Policy of the Fund

One additional consideration:

The way funds are invested (theinvestment policy) has important effectson the target funding level. Oneparticularly important consideration is therelationship between the performance ofthe assets and the expected liabilities ofthe DIA.

• Positive correlation between assetsand liabilities.

• Negative correlation between assetsand liabilities.

19

assetsprices

PD

assetsprices

PD

Results -The Colombian Case

• 20,000 trials were performed based onthe PD of the insured institutions andthe correlations between them.

• Determining a percentile of coverageassociated to a level of risk

• Econometric model approach: 2.5%

• Rating agencies approach: 1.5%

20

Right tail of the loss distribution function of the Colombian DIA

2.0% 98.0% $ 14.47 6.9%

Target Fund

($COP bn)

Deposit Insurance Target

Fund as a Proportion of the

Eligible Deposits

PD

Percentile of the loss

distribution

associated to the PD 80%

82%

84%

86%

88%

90%

92%

94%

96%

98%

100%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

1 6 11 16 21 26 31 36 41

Probability Cumulative probability

$ Billion

The investment policy:

• 85% of the DIA fund is invested in foreign currency assets and 15% in local government bonds.

• 100% of the credit contingency line is in foreign currency.

• Any crisis scenario (given past performances) comes with a depreciation of the peso of 30% and local government bonds increase its rates of return by 300 basis points.

• Then our target level is 5.5% of total insurable deposits.

• Taking into account the recovery rate: of the 5.5%, 4.1% should come from premiums and 1.4% form alternatives sources of funding. (Appendix)

21

4.1%

1.4%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0% 5.5%

Results -The Colombian Case

3. Colombian Case – Timeline

2011

- Historical analysis.

- Analysis of theratio (Reserve /

Insurable deposits)

2012

- Statistical methodology

- Funding scheme

2013

- Flexibility in premium scheme

2014

- Other funds sources

A Remainder

Principle 9 – SOURCES AND USES OF FUNDS

The deposit insurer should have readily available funds and all fundingmechanisms necessary to ensure prompt reimbursement of depositors’ claims,including assured liquidity funding arrangements. Responsibility for paying thecost of deposit insurance should be borne by banks.

Essential criteria

…

5. After establishing an ex ante deposit insurance fund:

a) the target fund size is determined on the basis of clear, consistent andtransparent criteria, which are subject to periodic review; and

b) a reasonable time frame is set to achieve the target fund size.

23

• Legal framework only allows toincrease premium when the DIF isdepleted.

• considering the current averagepremium level (0.27%), the 4.1%target would be reached in 15years.

• In 2013, we proposed a change inthe law, trying to do more flexiblepremium scheme.

24

3.0%

3.2%

3.4%

3.6%

3.8%

4.0%

4.2%

4.4%

20

13

20

15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

20

23

20

24

20

25

20

26

20

27

20

28

20

29

R / ID (P: 0.27%) R / ID (P: 0.30%) R / ID (P: 0.35%)

R / ID (P: 0.40%) R / ID (P: 0.45) Nivel Objetivo

6 years 7 years 9 years 12 years 15 years

Forecast of the ratio DIF / Insurable deposits

Flexibility in premium scheme

3. Colombian Case – Timeline

2011

- Historical analysis.

- Analysis of theratio (Reserve /

Insurable deposits)

2012

- Statistical methodology

- Funding scheme

2013

- Flexibility in premium scheme

2014

- Other funds sources

• It is the right moment to look foralternative funding sources.

• Contingent credit line with multilateralorganizations: the amount offered bymultilateral organizations is low andaccess to these resources affect theNation Government availability of funds.

• Products offered by reinsurers: theamount offered is higher.

26

Other sources

• GDP Growth: 4.6%• Inflation rate: 3.7%• Unemployment rate: 8.7%• Central Bank Policy rate: 4.5%• Fiscal deficit: 2.3% of GDP• Public Debt: 36.6% of GDP

S&P Fitch Moody's

BB-

BB

BB+

BBB-

BBB

Agenda

1. Introduction

2. How Fogafín dealt with the financing of the last financial crisis

3. Colombian case

4. Future challenges

5. Final remarks

27

4. Future challenges

In December 2014, Fogafín established a strategic plan 2015 -2019:

• To get the approval of the target ratio by the Board of Directors.

• To reach at least 75% of this target by 2019.

• Given that a high percentage of thefund is invested in foreign assets, theratio DIF / insurable deposits is asvolatile as the exchange rate.

• We are evaluating to use a movingaverage to get a smoother ratio.

4. Future challenges - Ratio volatility

3.8%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

mar

.-1

0

jun

.-1

0

sep

.-1

0

dic

.-1

0

mar

.-1

1

jun

.-1

1

sep

.-1

1

dic

.-1

1

mar

.-1

2

jun

.-1

2

sep

.-1

2

dic

.-1

2

mar

.-1

3

jun

.-1

3

sep

.-1

3

dic

.-1

3

mar

.-1

4

jun

.-1

4

sep

.-1

4

dic

.-1

4

Fund / Insurable Deposit

DIF as a Proportion of the Eligible Deposits

4. Future challenges - Split DIF and Resolution Fund

Demirguc-Kunt, Kane and Leaven (2014). Deposit Insurance Database. http://www.imf.org/external/pubs/ft/wp/2014/wp14118.pdf

22 Fogafín

31

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0% 5.5%

4. Future challenges - Split DIF and Resolution Fund

5.0%

0.5%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Resolution Fund DIF

Target Ratio= 5.5%

Agenda

1. Introduction

2. How Fogafín dealt with the financing of the last financial crisis

3. Colombian case

4. Future challenges

5. Final remarks

32

5. Final Remarks

• The DIA contributes to the financial stability by reducing the incidence andseverity of bank runs. The resources available to the DIA to finance its mandateare a critical part of its ammunition when banks face an insolvency event.

• Therefore, by having sufficient resources the DIA contributes to restore ormaintain the stability of the financial system in times of crisis. Setting a explicittarget funding level is critical.

• The methodology presented is a way to formally determine the target fundinglevel of a DIA, taking into account recoveries of the liquidation process and theinvestment policy of the funds.

33