DEPOSIT PROTECTION IN CANADA
AT FINANCIAL INSTITUTIONS
INSURANCE IN CANADA
Establishment of CDIC
Co-existence of Two Deposit Insurance Systems
PERIOD OF QUESTIONING AND ADJUSTMENT
A: TABLE OF PAYMENTS AND/OR RESTRUCTURING COSTS AND ESTIMATED LOSSES
B: PARTIAL LIST OF REPORTS AND STUDIES ON DEPOSIT INSURANCE
C: "CAUSES OF LOSSES"
D: COMPARISON TO PROPOSALS TO PROMOTE MARKET DISCIPLINE IN A CONTEXT
OF DEPOSIT PROTECTION
DEPOSIT PROTECTION IN CANADA
Deposit protection systems,
some private, some public, some mixed, exist worldwide. The Canadian system
is public at the federal and provincial level, compulsory, and covers
banks, trust and loan companies, caisses populaires and credit
unions. The systems operations are, however, intended to resemble
those of the private sector. Why this approach was adopted and whether
it is possible to go further in this direction are the questions raised
in this paper. In the overview of depositor behaviour, we stress that
people must trust the financial system if it is to function; we go on
to examine whether deposit protection is necessary.
After comparing federal
financial institutions with respect to the holding of deposits, compensation,
and supervision, we describe the instruments provided by law for each
type of institution. Lastly, we see how CDIC has developed from its founding
in 1967 to the present by describing the legislative amendments it has
undergone. This leads to a consideration of the problem of "moral
hazard" associated with deposit insurance and to certain proposals
for supervision and market discipline for deposit institutions.
AT FINANCIAL INSTITUTIONS
Canadian financial institutions
carry on activities in the fields of banking and trusts, insurance and
securities. Banking is strictly under federal jurisdiction, while trusts,
savings and insurance are joint federal and provincial fields; securities
activities are an exclusively provincial field.
Of these institutions, only
banks, savings banks, trust companies and credit unions may hold public
deposits. Deposit-holding is an exceptional activity since deposits are,
in a way, "lent" to the institution. The activities of deposit-holding
institutions are therefore contingent on a promise of repayment and, as
such, are planned very differently from those of institutions that sell
a product. Insurance and securities are very different fields, and there
are private markets for insurance and brokerage customer protection. In
this paper, we shall address only deposit insurance, and particularly
the federal system, which covers the banks, trust and loan companies that
belong to it.
The map below shows the
distribution of deposits held by the various deposit-holding institutions
in each province. The assets of deposit institutions represent roughly
one half of the financial industrys total assets, a fact that clearly
indicates their importance. Though deposits are mainly concentrated in
banks and in the Central Provinces, banks hold the majority of deposits
in every province, and 63.2% of Canadian deposits as a whole.
The trust that depositors
place in the system holding their deposits is an essential factor in the
systems operation. This trust is based on the information available
on the institutions. With the development of telecommunications and computerization,
instruments have become more numerous and information more abundant. However,
for making informed choices, depositors prefer the information on their
deposits and on factors likely to affect them to be correct rather than
Information likely to be
of interest to depositors may concern the internal behaviour of the institution
they deal with, its external behaviour, or the economy in general. In
principle, we can agree that market forces should encourage institutions
to earn the trust of their depositors; otherwise, depositors may choose
to withdraw their money and deposit it at another institution, or demand
a premium as compensation. A "run" on a single institution may
simply be the result of poor business decisions or indicative of the level
of risk an institution is taking. Depositors concerns may then be
fed by their fear of having to bear the risk assumed by their institution,
and may ultimately force the institution to stop its activities. The disappearance
of an institution is not a bad thing for the economy per se,
since agents enter and leave any efficient market. of that disappearance
may, however, affect the public interest, and this is all the more significant
because a number of institutions are affected at the same time. When the
behaviour of institutions in general becomes a concern, there is a risk
of a run on all deposit institutions. This type of phenomenon is hard
to control and may have serious consequences for the financial system
and economy as a whole.
It is therefore necessary
to determine clearly the reasons for "runs" and to what extent
they are caused by incomplete or incorrect information(1)
about an institution. Once the cause has been identified, it is easier
to take the appropriate steps.
We have already seen the
importance of depositor confidence for the stability of the financial
system. In the context of deposit protection and in case of disaster,
an implicit feeling of being protected has tended to discourage any formal
demand for such protection. In Canada, there has never been a demand for
a private deposit insurance system, so no such system has ever formed
on its own. The absence of a market may at times justify government intervention
(in various forms), particularly when this absence has led to substantial
distortions. Government intervention in this case is designed to correct
the distortion caused by runs on deposit institutions. It is for this
reason that deposit insurance was established.
On balance, from an economic
point of view, government intervention with respect to financial institutions
tends to protect the financial system as a whole. In the same way, a public
deposit insurance system must solve the problems caused by a difficult
general situation. However, it must also keep depositors alert so that
they can play their proper active role in a market economy such as ours.
Lastly, it is important to be able to combine instruments such as supervision
and regulation, for example, and to modify the role played by the private
sector within the existing deposit insurance system. An examination of
the federal deposit insurance system shows how these factors may vary.
Any consideration of the
deposit sector in Canada must, of course, include the legislative framework
for financial institutions. Canadian legislation reforming federally chartered
financial institutions passed on 1 June 1992 sets out, inter alia,
the conditions for deposit-holding, compensation and supervision.
Banks, trust companies and
loan companies, which are federal and so-called "deposit" institutions,
may hold deposits if they are members of the Canada Deposit Insurance
Corporation (CDIC). Insurance and mutual aid companies may not accept
deposits without the Ministers approval. Lastly, credit cooperatives
may hold deposits with the Ministers permission or in cases where
deposits come from local cooperatives. In Canada, cash and deposits(2)
totalled more than $450 billion in 1991.
The Canadian Payments Association
(CPA) regulates a national clearing system for deposit institutions. Chartered
banks and the Bank of Canada are required to be members, and the other
deposit institutions may belong if they meet eligibility criteria. In
all cases, deposits are eligible for clearing only if they are made with
members of a group designated by the CPA. Under the CPAs federal
constituent statute of 1980, the Associations goals are to establish
and implement a national clearing and settlement system, as well as a
system for planning the development of a national payments system. As
of 31 December 1991, the CPA covered 13,259 branches, slightly
more than 11,000 of which belong to direct members.
Banks and trust and loan
companies under federal jurisdiction are required to apply to CDIC for
deposit insurance. In the case of insurance and mutual companies, policy
holder protection may be provided through a compensation association designated
by ministerial order. Part XVII of the Cooperative Credit Associations
Act provides for CDIC intervention with respect to compensation, even
though membership is not mandatory.
Prior to 1980, CDIC came
to the aid of only two trust companies. In both cases, there was full
recovery.(3) Since 1980, CDIC
has been required to make payments in respect of more than 20 deposit-taking
institutions. Two examples are the Canadian Commercial Bank and the Northland
Bank, which collapsed in the mid-1980s, although wind-up operations for
the latter were not completed until the fall of 1991.
In the case of private compensation
plans,(4) the situation has
remained calmer. The recent case of Les Coopérants is the first
in which the Canadian Life and Health Insurance Compensation Corporation
(Compcorp) has had to intervene. The compensation association created
for property and casualty insurers (PACIC) has not yet been tested.
The Canadian financial system
has a number of organizations with responsibility for supervising financial
institutions, including deposit-taking institutions.
In 1923, following the collapse
of the Home Bank, Canada appointed the Inspector General of Banks, who,
as the name implies, was responsible for inspecting banking institutions.
The Bank of Canada was founded somewhat later, in 1934. By using the instruments
at its disposal, the Bank establishes the general credit conditions under
which deposit-taking institutions operate. In addition, as lender of last
resort, the Bank of Canada makes loans to deposit-taking institutions
to meet short-falls in liquidity.
Financial institutions (including
deposit-taking institutions) now come under the authority of the Superintendent
of Financial Institutions, who inspects their operations and imposes specific
rules of conduct. The Office of the Superintendent of Financial Institutions
(OSFI), which was created in 1987 through the merging of the Office of
the Inspector General of Banks and the Office of the Superintendent of
Insurance, assesses the institutions solvency and authorizes or
recommends continuation, reorganization or suspension of activities. In
the case of CDIC member institutions, the Superintendent examines the
operations of every member on behalf of the CDIC "once each year
and at such times as the Corporation may require."(5)
This brief review of the
federal legislative framework illustrates how control of the operations
of deposit-taking institutions is carried out at a number of levels, ranging
from self-supervision (practised by the institutions themselves) to public
supervision. The legislative framework provides a number of instruments
and allows some flexibility in their use.
Since the level of trust
in the system and in certain specific financial institutions is related
to the information available to the public, such information is the means
whereby deposit-taking institutions make known their relative stability.
Public policy instruments used to respond to an absence of a private deposit
insurance market are mainly designed to protect depositors and the system
as a whole.
INSURANCE IN CANADA
When deposit insurance was
introduced in Canada, financial institutions were much less developed
than they are today.
It is easy to understand
why there might be little confidence in very small institutions. Times
have changed, as have consumer habits. The use of cheques and electronic
transfers is increasingly common and generally accepted. The issue of
trust continues to be crucial to the stability of the financial system,
except that, because of the way the institutions have developed, it does
not hinge on the same features. Trust now depends more on the behaviour
of deposit-taking institutions than on the liquidity of the deposits.
The risk of hoarding is no longer nearly as great as it was a few decades
ago. Depositors today appear to be more mobile; that is to say, instead
of keeping their money at home, they are more likely to respond to insecurity
by moving their deposits from one institution to another. The signals
sent by depositors are now aimed more at specific institutions than the
Establishment of CDIC
The absence of a private
deposit insurance market and the relatively disparate sizes of deposit-taking
institutions resulted in public intervention to create a certain level
of trust in the institutions. This intervention led to the founding of
The federal deposit insurance
system was introduced in Canada in 1967 partly to "reassure"
worried depositors. The motives underlying the Canadian system are implied
in the following passage from the 1967 Senate Debates:
... Bill C-261, to establish
the Canada Deposit Insurance Corporation has, ... a philosophy ... summarized
by saying that the purpose of the bill is to ensure the safety of the
savings of individuals who as depositors use the financial institutions
of this country for that purpose. It is also intended to stimulate confidence
in our deposit-taking institutions in a country where, with sound management
of our affairs, the expansion and business activity and the multiplication
of banking facilities and deposit-taking institution facilities are
almost certain to develop as rapidly as our economy grows.(6)
It should be noted that
it was anticipated at the time that trust and loan companies would develop
into deposit-taking institutions. The Canada Deposit Insurance Corporation
bill received Royal Assent on 17 February 1967. CDIC was established
as a preventive measure to counter certain "disturbances" that
might harm Canadas financial system. From an operational point of
view, like an insurance company, it was to manage a fund financed by premiums,
but with the exception that it could be given additional authority.
The functions of the CDIC
were originally set out as follows:
- CDIC was authorized to acquire assets
of a member institution, to grant loans and advances and guarantee them,
and to guarantee loans to or deposits with a member institution;(7)
- CDIC could act as receiver for a failed
institution and pay depositors claims of up to $20,000 per depositor
by depositing cash or transferring this sum to another institution;(8)
- CDIC could collect an annual premium
equal to at least $500, or one-thirtieth of one per cent of the total
amount of deposits, whichever was greater.
In addition, CDIC was responsible
for developing standards for the activities of non-federally chartered
trust and loan companies. This measure was to be applied jointly with
the Quebec Deposit Insurance Board (QDIB) to improve minimum financial
and management standards.(9)
The number of financial
institutions has greatly increased since CDICs inception. Some of
them encountered serious difficulties in the 1980s, however, and were
forced to turn to CDIC.(10)
Co-existence of Two Deposit Insurance Systems
The Province of Ontario
enacted the first Canadian deposit insurance legislation but, with the
establishment of the CDIC shortly thereafter, the provincial statute was
amended to enable provincial institutions to benefit from coverage by
the federal corporation. In all provinces except Quebec, legislation was
amended to avoid duplication of services.
In 1968, Quebec established
its own deposit insurance system (QDIB), to which any non-bank financial
institution which solicits or receives deposits in Quebec must subscribe.
The Canada Deposit Insurance Corporation Act was amended on 27 March 1968,
and an agreement with QDIB was signed in December of that year. These
changes allowed and still allow CDIC:
- to provide coverage for deposits outside
Quebec accepted by institutions incorporated in Quebec;
- to insure deposits in Quebec of institutions
incorporated in other provinces, provided there was no other agreement
with the latter; and
- to provide assistance to QDIB in case
of a need for liquidity.
QDIB activities began in
1970. As of 30 April 1991, deposits insured by QDIB and CDIC
totalled $58 billion and $290 billion respectively. According to QDIBs
1991 annual report, roughly half (51%) of deposits guaranteed by that
agency were with savings and credit unions. Next, but lagging far behind,
came federal savings banks (27%) and trust companies incorporated under
Quebec law (17%). In contrast, according to CDICs annual report
figures, the majority of insured deposits (92%) are in federal member
institutions, including banks and trust and loan companies. The balance
of CDIC-insured deposits is in provincially incorporated trust and loan
In 1981, QDIB asked for
CDIC assistance, as provided under the 1968 agreement. CDIC advanced $55
million to enable QDIB to meet its short-term liquidity requirements.
QDIB had entirely repaid the amount by June 1982.
As stated above, CDIC was
established by an Act passed in February 1967. The agency, headquartered
in Ottawa, was managed by a Board of Directors consisting of a Chairman,
the Governor of the Bank of Canada, the Deputy Minister of Finance, the
Superintendent of Insurance, and the Inspector General of Banks. The first
Chairman of the Board was Mr. Antonio Rainville. Since CDIC had a
small staff in its first decade of existence (its employees could in fact
have been counted on the fingers of one hand), CDIC called on the services
of the Department of Finance and the Office of the Superintendent of Insurance.(11)
CDIC operates basically
as an insurance company. It differs from a private company in that the
insurance it provides is mandatory, and the corporation has the privilege
of being able to borrow from the government within authorized limits.
Unlike all other insurance companies under federal jurisdiction, it is
not supervised by the OSFI.(12)
The federal government originally
subscribed $10 million in capital funds for CDIC. In addition to premiums
charged to members, the deposit insurance fund, which can be augmented
through federal government borrowings, originally could not exceed $500
By 31 December 1967,
CDICs membership included 11 banks and 18 federal loan and trust
companies, as well as 41 provincial member institutions. As seen above,
the CDIC Act was first amended in 1968 as part of the agreement with QDIB.
Added to the Act at that time was a definition of "deposits"
which had previously existed only in the Corporations by-laws.
The Act was amended a second
time in 1977 by Bill C-3. CDIC obtained the right to buy back its
capital stock for $10 million; however, this in no way changed the property
rights or control of the Corporation, which remains an agent of the Crown.
Furthermore, in view of the proper operation of its activities and those
of its members, the Corporation was given the option, with the passage
of Bill C-3, of allowing reductions on the premiums charged to its
members. This amendment, which was likely motivated by a more comfortable
budgetary situation, can be seen as an incentive to member institutions.
The premium that CDIC charges
its members is proportional to the insurable deposits they hold. Institutions
can forecast the premium owed; however, the fact that the premium may
be reduced by a specific amount on the basis of good behaviour ratings
or measures leading to sound financial health provides an incentive for
institutions trying to reduce costs to improve their behaviour. A fixed
rate for member institutions means a non-flexible cost to the institution.
However, a premium that varies with the level of risk or management rating,
for example, may possibly have some influence on institutions decisions,
because it affects their cash flow.
In the United States, the
CAMEL system(14) was proposed
for setting the amount of the premium. This system in fact provides two
premiums: a medium and a high risk premium. In Germany, premiums may vary
as required; this is also the case in the United Kingdom when reserves
are exhausted. Premiums are an instrument that may be used for the purposes
of financing and/or supervising assets, particularly their quality.
The charts below show how
CDICs situation has evolved over the years. As they indicate, CDICs
situation during its first decade was relatively comfortable. Toward the
early 1980s, more than 100 member institutions paid CDIC premiums totalling
approximately $20 million per year, and its Deposit Insurance Fund showed
a cumulative surplus of approximately 10 times that amount. Things were
indeed going well, but it should not be forgotten that, since its inception,
CDIC had only rarely been required to compensate depositors. The 1980s
proved more difficult and raised questions.
The number of deposit-taking
institutions has changed over the years. From 1975 to 1985, the number
of member institutions rose from 83 to 177. This increase was due
in part to the entry of trust and loan companies into the market.
It has been easier for foreign banks to carry on their activities
in Canada since the Bank Act was amended in 1980. Those banks
hold only a small share of Canadian deposits, but their entry in the
market nevertheless explains most of the increase in the number of
member institutions starting in 1980 (there were a total of 123 members
in 1980). In the past few years, however, as a result of problems
encountered by financial institutions, the number of institutions
appears to be returning to its level of the early 1980s. However,
the decline is not mainly caused by a decrease in the number of banks,
but rather by a decrease in the number of federal and provincial trust
and loan companies.
The required premiums
on insured deposits are CDICs prime source of financing. The
premiums received by CDIC jumped sharply in 1986 following a legislative
amendment, which raised the rate, charged. Apart from that, that may
explain the change in premiums in insured deposits. CDIC-insured deposits
are mainly held by banks, followed by federal trust and loan companies,
then provincial companies.
The fund grew steadily
until the early 1980s, but, to meet its obligations, CDIC had to borrow
from the government for the first time in 1983 ($140 million). In
overall terms, the balance of the CDIC Deposit Insurance Fund, which
had been growing regularly since 1967, posted a deficit starting in
1983. In its most recent annual report, CDIC announced a $590 million
deficit for the Fund. CDIC expects to repay all its debts by 1996.
PERIOD OF QUESTIONING AND ADJUSTMENT
As noted above, CDIC was
established to insure the deposits of individuals who bank with financial
institutions under federal jurisdiction and to encourage confidence in
deposit-taking institutions; its establishment preceded significant developments
in those institutions and the financial sector in general.
system has changed vastly with time. The relative weight of the financial
institutions is not the same as it was, and their field of activity has
generally expanded. In addition, new technologies facilitating bank transactions
and the international expansion of banking activities show significant
change in the competitive climate. In these circumstances, one may well
wonder what will become of deposit protection.
The relative equilibrium
of the CDIC fund was shaken by the poor state of a number of financial
institutions, particularly during the 1980s. The Trudeau and Mulroney
governments each amended legislation in 1983 and 1986 respectively, to
give CDIC more room to manoeuvre. Since 1967, "small" depositors
had been covered for up to $20,000 and the Corporations coffers
had been replenished on this basis. When the CDIC Act was amended in 1983
to increase coverage to $60,000, it became clear that the Corporation
would have to be allowed to borrow more. The maximum level of borrowings
from the government was increased from $500 million to $1.5 billion. In
addition, greater premium financing was authorized under Bill C-86, passed
This bill enabled CDIC to
add private sector members to its Board of Directors. In addition, the
premiums charged to members rose from one-thirtieth of 1% to one-tenth
of 1% of insured deposits. Revenues were thus enhanced, and private sector
members had the opportunity to influence CDIC management decisions.
Prior to 1980, there were
only two cases where financial institutions got into difficulty and received
CDIC assistance.(15) Despite
the changes made to the CDIC Act (in particular, tighter supervision and
higher premium rate), CDIC found itself in deficit. It had to borrow from
the government and spread its repayment over a number of years.
Member institutions receiving
loans from the CDIC were either subject to takeover or experiencing financial
difficulties. The Corporation intervened on its own but also on the advice
of the Superintendent of Insurance. Settlement of cases submitted to the
CDIC has generally taken several years. For example, wind-up of the Northland
Bank took over seven years to complete.
In most cases, CDIC paid
back all deposits, whether or not they were insured. While this CDIC decision
to provide 100% compensation may be explained by the Corporations
objective of minimizing cost and risk,(16)
the indirect effects of such a measure may raise problems. Some maintain,
for example, that the political cost must be taken into account(17)
in interpreting the results of a policy affecting deposit-taking institutions.
These events led to a general
questioning of the role of the deposit insurance system, and to a realization
that it may harm market discipline to have depositors assured of being
entirely reimbursed. Depositors confident of being compensated (even when
by law their deposits are not insured) are less likely to take care that
their deposits are placed in sound institutions. This is what is meant
by "moral hazard," a term used by economists to describe a problem
of asymmetrical information(18)
frequently encountered in insurance. In the words of J.E. Pesando:
Moral hazard is said to
exist whenever the act of insuring an event increases the probability
that the event will occur. Deposit insurance, in effect, insures against
the failure of a financial institution. In so doing, it increases the
likelihood that such a failure will occur.(19)
When depositors are not
concerned about their insured and uninsured deposits, institutions have
greater freedom of action with respect to the funds at their disposal.
A number of studies have shown how risk-taking may at times become relatively
excessive. In a study published in 1983, entitled The Wyman Report:
An Economists Perspective, Pesando mentioned certain factors
that may prompt a risky approach to management. He first mentioned the
case of institutions studied in 1983, where there was asymmetry between
the risk borne by shareholders(20)
and that borne by other creditors (depositors). This encouraged risk-taking
on the part of the shareholders managing the company, and this grew if
they felt less supervised. According to Pesando, a member institution
can start to think that its management does not need to take the reactions
of depositors into account. Furthermore, an institution may respond to
regulations by automatically going as far as the limits permit.
Pesando emphasized that
managers may attach less importance to portfolio diversification in the
absence of insurance. He observed that deposit insurance insures against
bankruptcy, but that in doing so it increases the probability that bankruptcy
will take place.
Among the means Pesando
suggested for eliminating excessive risk-taking in members institutions
- increased capital requirements to a high
enough level that managers internalize the costs of risk-taking;
- introduction of a risk-based system;
- stricter and more rigorous supervision
- implementation of a co-insurance system;
- requirement that each insured institution
have a percentage of deposits in the form of subordinated debt in case
According to a study by
the Economic Council of Canada,(21)
although external factors (the economic situation) have contributed to
Canadian bankruptcies, internal factors (internal risk management: loan
quality, degree of diversification, size of capital base and balance between
assets and liabilities) were mainly responsible for those bankruptcies.
A number of solutions are
therefore available for the problem of deposit-related moral hazard. These
solutions can be combined for even greater flexibility. Generally speaking,
this may involve using means that affect the decision-making criteria
of deposit-taking institutions. These means may be more or less direct;
that is, they may be purely regulatory and thus impose a direct constraint
on institutions, or they may be indirect and take the form of incentives.
For example, adoption of a risk-based premium rate structure may be a
way of making an institution more cautious. Incentives designed to make
depositors aware of their institutions actions may be another method
of achieving this. Thus, direct or indirect regulatory power may be applied,
depending on the objective. Identifying the roles of the CDIC on the one
hand and public supervisory agencies on the other is necessary in order
to avoid duplication and conflicting measures. Insofar as a public deposit
insurance system fills the place of a private market that does not exist,
we can envisage a framework of responsibility and supervision for it similar
to the one that would prevail in a private system.
In practice, the CDIC
Act was amended twice: first by Bill C-42 in 1987 and second by Bill
C-48 in 1991. These amendments were made in the context of the federal
governments financial institution reform. Indeed, as Mr. Hockin
noted, Bill C-42 marked the initial steps in a concrete process toward
the globalization of financial markets.
In 1987, Bill C-42(22)
amended some of CDICs functions and introduced measures designed
to enhance market discipline and supervision. The bill provided for the
merging of the Office of the Superintendent of Insurance and the Office
of the Inspector General of Banks into a new entity, the Office of the
Superintendent of Financial Institutions. The bill included a number of
amendments concerning CDIC: a change in membership of its Board of Directors,
the option of charging premiums reaching one-sixth of 1% of insured deposits,
a new role in developing sound financial practices and responsibility
to promote public awareness of deposit insurance, as well as an increased
ceiling on its government borrowings, from $1.5 billion to $3 billion.
These changes were a sign
of a more centralized federal approach to financial institutions. Requiring
institutions insured by CDIC to pay an additional premium if they did
not adopt sound practices could act as an incentive to prudent behaviour.
In practice, however, this power has never been used by CDIC. Furthermore,
the threat of an increase in the premium rate in the Corporations
last budget was motivated by a need for additional funds to eliminate
the forecast deficit, rather than by any need to affect the conduct of
member institutions; this provision was evidently strictly budgetary in
Advertising designed to
increase public awareness may be an important influence on how depositors
feel about their institutions. It may, among other things, be used to
ensure that all depositors, large and small, know that some of their deposits
are insured. It is difficult, however, to determine the real impact of
this measure. Nevertheless, if institutions consider that their clients
(depositors) are better able (or more motivated) to keep an eye on their
deposits, they have to take this into account in their decision-making.
The measures discussed above
seem aimed more at institutions and depositors than at the Corporation
itself. CDIC is authorized to intervene with its members, normally after
consultation with OSFI, which is responsible for supervising and examining
financial institutions under federal jurisdiction. When the discussions,
which may be long and difficult, are concluded between the regulatory
agencies and the institutional managers, CDIC comes into play, but by
then, the game is largely over.
Where the business of one
institution is merged with or transferred to another and it proves difficult
to obtain the agreement of shareholders and creditors, it may be necessary
to pass special statutes. For example, to resolve the difficulties surrounding
the transfer of business from the Bank of British Columbia to the Hong
Kong Bank of Canada in 1986, a special Act was passed and CDIC was given
the responsibility of seeing to the smooth transfer of business. Since
then, CDIC has been promoting the view that this process should be provided
for on a systematic rather than a "case-by-case" basis. Bill
C-48, an Act to amend the Canada Deposit Insurance Act, adopted in 1992,
concerned the time at which CDIC should intervene.
Bill C-48 is thus largely
devoted to providing for a Financial Institutions Restructuring Program
(FIRP) and to giving the Corporation new means of taking charge of those
financial institutions under federal jurisdiction whose financial liability
has been questioned by the regulatory authorities. Under the new provisions,
an institution, which is the subject of a restructuring order, may be
sold or merged without the approval of its shareholders or creditors.
Lastly, under this bill,
the limit on the amount the Corporation may borrow from the government
was raised from $3 billion to $6 billion. Amendments were also
made to allow provisions regarding advertising for deposit insurance to
be grouped together in the administrative regulations.
As a whole, then, the measures
taken with respect to deposit insurance in the wake of numerous bankruptcies
and solvencies in the 1980s have concentrated on financial requirements
and amending the CDICs powers. In its most recent corporate plan,
CDIC has adopted the following roles:
- to provide insurance against risk of
total or partial loss of deposits;
- to participate in establishing standards
for sound business and financial practices in member institutions, to
promote the stability and competitiveness of the Canadian financial
system, and to cooperate in promoting stability and competitiveness;
- to pursue the preceding two objectives
in the interests of persons holding deposits with member institutions
and in such a manner as to minimize the Corporations exposure
Thus, the CDIC now sees
its role in a much broader perspective than in its early days. Its staff
is much larger, and an interest in increasing its role is even more evident
in the objectives stated in its last annual report.
According to economic theory,
government intervention may be justified by certain market imperfections
- in this case, the absence of a market for deposit insurance. Given the
types of risk and uncertainty common in the insurance sector, market imperfections
are often caused by asymmetrical information resulting in moral hazard
or adverse selection.
Most economists agree that
risks of bankruptcy under a voluntary deposit insurance system are higher
than under a compulsory system, since the weaker institutions are more
likely to join a deposit insurance system. With a compulsory system like
Canadas, the problem of adverse selection is not applicable, even
though member institutions are characterized by various degrees of risk.
The various sizes of CDIC member institutions suggest that a voluntary
system would be likely to attract smaller and more fragile institutions.
Events in the history of
deposit insurance in Canada have not called its mandatory nature into
question. However, there is still the problem of moral hazard referred
to above. The means recommended by Pesando in 1985 were restated by Lang
five years later, by which time Bill C-42 had been passed (in 1987). This
study points to certain problems that still require solution.
In light of a number of
reports and studies on various reform proposals in the past decade,(23)
Lang compares various scenarios, which can be summed up essentially as
having two complementary approaches: active supervision and market discipline.
The first approach involves detection and correction of illegal and imprudent
practices and, briefly put, is designed to increase consumer protection.
The second approach motivates institutions to internalize the cost of
their activities. In other words, so-called risky activities are pursued
only if they are justified by a market price; that is why the market discipline
label is applied.
In the area of active supervision,
the author examines the possibility of merging the CDIC with other regulatory
organizations and the possibility of giving it additional powers. Various
scenarios are based on the idea that supervision is carried out by OSFI,
with the CDIC not being equipped to handle inspections; thus, CDIC uses
the data of OSFI or member institutions. Consolidation of OSFI and CDIC
activities to create a "National Financial Administration Agency"
was proposed to the House of Commons by the Blenkarn Committee in 1985.
The 1986 Estey Report had also suggested a possible merging of CDIC with
the bank supervisor, the Inspector General of Banks (OSFI did not then
exist). The merger proposal was rejected by the government, which considered
that supervision and deposit insurance are separate activities and that
problems of federal and provincial jurisdiction might arise.(24)
On the other hand, the Wyman Commission had recommended giving CDIC additional
powers rather than a merger, observing (according to Lang) that these
powers might extend to supervision, examination and wind-up. However,
efficiency must be a consideration when powers are determined: the greater
the cost of adhering to CDIC guidelines, the more financial institutions
tend to innovate in unregulated fields where the CDIC cannot intervene.
Consequently, measures should be adopted that encourage other options
rather than limiting institutions to a restricted framework.
Authors of U.S. studies
have advanced the same idea. In the United States, for example, politicians
have at times attributed problems to fraudulent or dubious practices on
the part of institutions. There are figures that show, however, that the
estimated losses of U.S. savings and loans were mainly (two-thirds) due
to commitments made before deregulation or in conventional real estate
loans. In reality, only a small proportion of the losses were the result
of fraudulent investments, junk bonds or other non-real estate investments.(25)
The U.S. has recently undertaken a reform of its deposit insurance system.
Some suggest that the various deposit insurance systems have never been
functional over a long period because they are not in fact necessary to
protect the public or to maintain the stability of the financial system.(26)
It appears important that the structures proposed be open to change and
able to adjust to developments in the country.
The Federal Deposit Insurance
Corporation Improvement Act (FDICIA) put forward in the U.S. in 1991
is a reform plan based on the real risk of FDIC bankruptcy and the need
for taxpayer subsidies that could arise as a result. The reform would
- an additional $70 billion in financing
for the FDIC;
- promotion of regulation and supervision;
- adoption of a detection system to raise
the regulatory requirements on bank capital.(27)
The authors of some studies
consider that transferring the risk of a banks bankruptcy from the
Deposit Insurance Fund to depositors themselves, as provided under the
reform plan, is a contentious issue and that promotion of market discipline
on depositors by the government and the FDICIA should be encouraged.(28)
As some say, regulatory supervision is a poor substitute for market discipline
in the present financial market.(29)
As regards market discipline
in Canada, the five proposals discussed in Langs article are: co-insurance,
risk-based premiums, requirements of capital, subordinated debt, and disclosure.(30)
A comparison of these proposals leads Lang to favour setting the premium
based on the notion of risk, increased reserves and the use of subordinated
debentures to permit CDIC to become more effective in its operations.
Lang also places some emphasis on disclosure. He suggests that the possibility
of integrating CDIC with provincial and industry funds should be examined.
Of course, these proposals
may involve some regulatory supervision; however, these methods, which
focus on market discipline, offer the parties greater flexibility and
enable them to adjust to their requirements more effectively and in the
A consensus in favour of
the use of subordinate debentures appears to emerge from the studies on
market discipline.(31) This
idea, advanced by Pesando among others, consists of obliging the institutions
to issue subordinated debentures (uninsured and at a fixed rate) backing
their uninsured deposits. The risk is related to the situation of the
institution itself rather than to the group of institutions to which it
belongs; this helps prevent systematic runs on a group of institutions
deemed to be riskier, as could happen under a co-insurance system, for
In addition, introducing
this approach would be more practical than a system based on risk, such
as the CAMEL system proposed in the United States, whose implementation
in the Canadian context many considered would be difficult. The use of
subordinated debentures could make the institution aware of the degree
of risk associated with the deposits, which, in practice if not in principle,
have always been insured.
requirements rules developed by the Basel Committee of the Bank for International
Settlements (BIS) in 1988 cannot be overlooked. Under this initiative,
the world banking system would have been subject to similar regulation
by the various national agencies. It was thought that an institution falling
under the BIS rules would thus be considered less risky than an unregulated
institution. Today, however, there is some doubt as to the effectiveness
of such a standard system.
It is difficult today to
foresee the introduction of standard rules. Flexibility and the ability
to adjust rules to local issues are important factors. Canada has established
a framework for capital requirements under its recent reform of financial
institutions. The concept of regulatory capital is defined by regulation(32)
for each type of institution and, for deposit-taking institutions, applies
in particular to real estate investments, capital and the overall limit
on certain transactions such as purchases and personnel improvements.
Lastly, there is the important
question of information. The authors of one study(33)
on CDICs problem, that is the inability to prevent member institutions
from taking excessive risks, also suggest enhancing market discipline
and regulation. They also assume that the solution depends on the efficient
introduction of procedures to improve the availability of information.
The most recent bill to
amend the CDIC Act was passed in 1992.(34)
Its principal measures were aimed at facilitating the transfer of an institutions
activities when shareholder cooperation is uncertain. This should be an
instrument of last resort, however, since, for the most part, agreements
reached seem to involve parties acting in good faith; even so, that in
no way alters the detection of problems which institutions sometimes face.
The detection activity carried out by the agencies responsible is a thorny
question, of course, but probably one amenable to solutions. The lag between
an institutions understanding that it is in trouble and the regulatory
authorities confirmation of that fact may be an important sign.
Thus, the problem of moral
hazard examined in the framework of the Canadian deposit insurance system
has led to a number of questions. Because the authors of certain U.S.
studies doubt the degree to which deposit insurance is justified, we should
not necessarily come to the same conclusion in Canada. Canadian deposit-taking
institutions are relatively smaller and much less numerous than their
U.S. neighbours. The distribution of risks is therefore relatively limited.
The Canadian deposit insurance
system was able at the outset to respond to a need to reassure depositors
about the safety of their deposits; however, times have changed. Cheques,
electronic transfers, automatic deposits and a host of other instruments
are now a part of daily life. Bank computerization has been achieved,
and automatic tellers have multiplied. In 1986, for example, Canadas
largest teller network, Interac was established. More than 11,300 automatic
teller machines now give cardholders Canada-wide access to their accounts.(35)
It was recently estimated that for every adult over the age of 18 years
there were 2.3 credit cards in circulation in Canada.(36)
Debit cards are increasingly being used to make purchases by debiting
a bank account directly. Cheques and cash are still used, but new payment
methods are becoming more popular. A few decades ago, depositors
confidence was determined by their concern about their ability to retrieve
a tangible amount owed, but this is no longer the issue. While the problem
of moral hazard gradually emerged after the establishment of a deposit
insurance system, the intangibility of payment transfer methods has accentuated
this tendency. People are less concerned about the physical location of
their deposits, and are quite happy to function with promissory notes.
This is good because transaction costs are certainly decreased as a result.
However, while the intangible nature of deposits partially explains why
depositors pay little attention to the institutions, adequate information
should certainly correct this situation.
Lastly, the risk of depositor
hoarding that used to exist before computerization and automation is now
likely very small. Lack of confidence in an institution should lead depositors
to turn to another that is in better shape. This indicates the part of
supervision that can be taken on by a depositor who has the necessary
information. As regards trust in the system in general, it is up to those
in positions of responsibility to assess the extent to which the cost
should be borne by taxpayers as a whole through the tax system, and the
extent to which it should be assumed by the more direct method, that is
by the private sector itself. The absence of a private deposit insurance
market in Canada can be explained by an implicit compensation insurance.
Why should this implicit insurance exist? As a first step, depositors
with accurate information should be able to identify institutions that
make poor management decisions. Public authorities could, for example,
examine the accuracy of information distributed to the public. This would
involve supervision of information, as well as of the amount of information
made public. CDIC currently discloses information as follows.(37)
It informs the public that future investments are no longer insured when
CDIC cancels or terminates an institutions membership and bolsters
the requirements for disclosure to consumers in cases where a deposit
is not insured. When a premium surcharge is imposed, the institutions
auditors MAY disclose the fact in their report. The rest of the information
disclosed may vary and depends on CDIC Board directives.
Thus, the deposit insurance
system no longer needs to respond to a risk of bank runs as it did when
it was established. When it becomes clear that institutions might not
wish to disclose information about themselves, regulatory instruments
must certainly be used. Legislators should bear in mind, however, that
regulatory supervision is a poor substitute for market discipline in the
present financial market.
Binhammer, H.H. and Boulakia,
J.D.C. "Deposit Insurance in Canada." The Canadian Banker,
Spring 1968, p. 38-45.
Canada Deposit Insurance
Corporation Act, R.S., 1985, c. C-3,
Canada, House of Commons.
Debates (Regarding Bill C-42).
Canada, The Senate. Proceedings,
CDIC. Annual Reports,
Canadian Bankers Association.
Banking Activities. 1991.
Cargill, T.F. and T. Mayer.
"U.S. Deposit Insurance Reform." Contemporary Policy Issues,
Vol. 10, July 1992, p. 95-103.
Carr, J. and F. Mathewson.
"The Effect of Deposit Insurance on Financial Institutions."
Department of Economics and Institute for Policy Analysis, University
of Toronto, WP 8903, March 1989.
Consumer and Corporate Affairs
Canada, Information. "Costs of Using Credit Cards." July 1992.
Economic Council of Canada.
The Framework of the Financial System. Document EC22-137,
Kaufman, G.C. "The
Truth About Bank Runs." C. England and T. Huertas, The Financial
Services Revolution: Policy Directions for the Future. Boston Kluwer
Academic Publishers, 1988, p. 9-40.
Lang, D. "Reform of
the Canada Deposit Insurance Corporation." Banking and Finance
Law Review, Vol. 5, February 1990, p. 167-195.
Mantripragada, K.G. "Depositors
as a Source of Market Discipline." The Yale Journal on Regulation,
Vol. 9, p. 543-574.
Meigs, A.J. and J.C. Goodman.
Federal Deposit Insurance: The Case for Radical Reform. National
Center for Policy Analysis, Policy Report No. 155, December 1990.
Pesando, J.E. "The
Wyman Report: An Economists Perspective." Canadian Business
Law Journal, Vol. 11, No. 2, February 1986, p. 105-120.
Smith, B. and R.W. White.
"The Deposit Insurance System in Canada: Problems and Proposals for
Change." Policy Analysis, Vol. XIV, No. 4, December
1988, p. 331-346.
TABLE OF PAYMENTS AND/OR
RESTRUCTURING COSTS AND ESTIMATED LOSSES
to 31 Dec. 1989
to 31 Dec. 1989
(in $ millions)
of British Columbia
West Trust Company
Savings and Trust
of Credit and
Commerce of Canada
City Trust Company
These estimated losses are based on the most recent data available
and do not take into account interest on sums borrowed by the
Corporation from the government.
** Financial Post,
Source: CDIC Annual Report,
1989; The Globe and Mail, Wednesday, 14 October 1992, table.
PARTIAL LIST OF REPORTS AND
STUDIES ON DEPOSIT INSURANCE
Canada. Working Committee
on the Canada Deposit Insurance Corporation (CDIC), April 1985 (Wyman
Canada, Department of
Finance. The Regulation of Financial Institutions: Proposals for
Discussion. Supply and Services Canada, April 1985 (Green Paper).
Canada, Standing Senate
Committee on Banking and Commerce. 10th Report. Deposit Insurance.
Supply and Services Canada, 11 December 1985.
Ontario Task Force on
Financial Institutions. Final Report. Queens Printer,
Toronto, December 1985.
Canada, House of Commons
Standing Committee on Finance, Trade and Economic Affairs. 11th Report.
Canadian Financial Institutions. Supply and Services Canada,
1985 (Blenkarn Report).
Canada, Standing Senate
Committee on Banking and Commerce. 16th Report. Towards a More
Competitive Financial Environment. Supply and Services Canada,
1 May 1986.
Canada. Report of
the Inquiry into the Collapse of the CCB and Northland Bank. Supply
and Services Canada, August 1986 (Estey Report: Canada, Working Committee
on the Canada Deposit Insurance Corporation (CDIC)).
Canada, Minister of
State for Finance. New Directions for the Financial Sector.
Supply and Services Canada, 18 December 1986 (Blue Paper).
- Economic Council of Canada. Competition
and Solvency: A Framework for Financial Regulation. Supply and Services
"CAUSES OF LOSSES"
The Politicians Search
for a Scapegoat
The Economic analysis of
the savings and loan crisis places the blame on Washington. Washington
seeks villains elsewhere. Some favourites among politicians are: fraud,
investments in junk bonds and the financial deregulation which permitted
S&Ls to make non-traditional loans. Yet these explanations are not
consistent with the facts.
Table IV presents one highly
regarded estimate of the various causes of S&L losses. As the table
- About 65 percent - the vast majority
- of S&L losses were incurred either before deregulation or in conventional
real estate loans.
- Only 3 percent of S&L losses can
be attributed to fraud.
- Only 2 percent of S&L losses are
attributable to investments in junk bonds.
- Only 2 percent of S&L losses can
be attributed to other non-real estate investments.
Other estimates may produce
slightly different numbers, but the overall conclusion is unlikely to
change. The evidence is consistent with the economists explanation.
It is inconsistent with the politicians search for scapegoats.
Deposit Insurance: The Case for Radical Reform," A.J. Meigs and J.C.
Goodman, National Center for Policy Analysis, Policy Report No. 155, December
S & L LOSSES:
Where the Money Went
on Pre-1983 Losses
Operating Costs at Insolvent S&Ls
Interest Paid at Insolvent S&Ls
Cost of FSLIC Deals
on Junk Bonds
on Other Non-Real Estate Investments
Source: Ely &
Co., Reprinted in Paulette Thomas, "Fraud is Called Small Factor
in S&L Cost," Wall Street Journal, 20 July 1990.
COMPARISON OF PROPOSALS TO
PROMOTE MARKET DISCIPLINE
IN A CONTEXT OF DEPOSIT PROTECTION
(goal: give depositors an incentive to monitor the activities
of their financial institutions)
· The insurance fund would reimburse
depositors only for a set fraction of insured deposits if the
financial institution were to become insolvent.
RISK-BASED PREMIUMS (Goal: response
to the "free-rider" problem; highest cost to protect
depositors in risk-seeking institutions would be paid by the
institution itself, thus discouraging risk-taking; subsidies
· An insurance premium should
reflect the insurers previous claims experience and an
assessment of future claims.
CAPITAL REQUIREMENTS (Goals: tendency
of financial industry to require more capital and larger reserves
maintained in the form of capital and of revenue to cover bad
· The larger the relative shareholder
equity, the higher the degree of risk internalized by managers
acting on behalf of the shareholders.
SUBORDINATED DEBT (may be biased
against smaller institutions)
- effective economic tool (complementary
to high capital requirement; forces management to internalize
risk; political gains)
· Obligation of issuing corporation
which ranks behind the deposits of the deposit-taking institution
DISCLOSURE (problem: difficulty
in obtaining information from institutions, particularly provincial
· Public disclosure of unsound
business practices should put market pressure on the institution.
- Wyman Commission proposals:
that the CDIC insure 90% of the first $100,000 of an individuals
- Alternative: that the first
$10,000 of deposits be fully covered and that the successive
deposits be insured at a lower rate.
- threat to regional policy
- unpopular with the public
because of the sacrifice of right to 100% coverage
- Wyman Commission rejected
the concept (difficulty in forecasting risk)
- the FCID has its CAMEL system
with a five-point risk scale which considers the asset quality
criterion essential and a better indicator of chance of failure
- possibility of disputes and
- practical system if the number
of risk categories is low, but this low number at the same
time imposes a single premium for a broad risk category
- the Bank of International
Settlements proposed minimum levels of capital for different
types of assets held by financial institutions
- OSFI does not publicly disclose
the specific capital requirements imposed on each Canadian
bank, making it difficult for the depositor to assess risk
- the Wyman Commission supported
the strengthening of capital requirements; suggested increased
equity requirements for new entrants; the establishment of
a definition of capital for all financial institutions (banks
and trust companies); a ratio which should be based on the
risk profile of the institutions rather than on the type or
size of institution.
- the Blenkarn Committee also
supported this, and recommended better regulation of the capital
requirements for subsidiary corporations
- strike a balance between need
for confidential supervision and the publics right to
- consider the CDICs need
to receive information on provincial financial institutions
from the provincial regulatory authority
Source: D. Lang, "Reform
of the Canada Deposit Insurance Corporation," Banking and Finance
Law Review, 5:167-95, February 1990.
G.C. Kaufman, "The Truth About Bank Runs," in The Financial
Services Revolution, C. England and T. Huertas, Boston Kluwer Academic
Publishers, 1988. Kaufman examines the validity of the reasons for a run.
He emphasizes that the public often confuses a run on a savings bank with
a general run on the entire system. He also stresses that government policy
should focus more on the stability of the system as a whole than on that
of any particular institution.
This is the monetary aggregate M2+ reported in the September 1992 issue
of the Bank of Canada Review.
A list of institutions for which payments and/or recoveries have been
made, and the estimated amount of losses, is provided in Appendix A.
Under provincial jurisdiction, in the securities field there was, for
example, the Osler case, in which the Canadian Investor Protection
Fund (CIPF) intervened.
Canada Deposit Insurance Corporation Act, s. 27(1).
Senate Debates, 16 February 1967, 1st Session, 27th Parliament,
p. 1447; second reading of Bill C-261, An Act to establish the CDIC.
Canada Deposit Insurance Corporation Act, s. 11. Taken from the
CDIC Annual Report, 1967.
H.H. Binhammer and J.D.C. Boulakia, "Deposit Insurance in Canada,"
The Canadian Banker, Vol. 75, No. 1, Spring 1968.
Charts illustrating the situation appear in the text below.
Staff increased at CDIC as the corporations activities were stepped
up. From 1981 to 1989, the number of employees rose from 6 to 63, and
to 92 in 1991. At the same time, CDIC managed total assets of $39 million
in 1981 along with approximately $1 million in liabilities per employee,
compared to slightly more than $9 million and $23 million per employee
respectively in 1989. The number of member institutions per CDIC employee
went from 24 in 1981 to two in 1989 and was approaching one in 1991.
OSFI does, however, oversee CDICs member institutions and reports
any problem to the Corporation.
CDIC, Annual Report, 1967.
CAMEL: Capital adequacy, Asset quality, Management ability, Earning quality,
Assistance provided by CDIC to its members is described in Appendix A.
CDIC annual reports, various years.
D. Lang, "Reform of the Canada Deposit Insurance Corporation,"
Banking and Finance Law Review, Vol. 5, February 1990; Lang
emphasizes that political pressure may exist.
Another type of asymmetrical information problem frequently encountered
in insurance is that of adverse selection.
Cited in Lang (1990).
He indicated that, in 1983, shareholder equity represented 3.82% of total
liabilities of the chartered banks, compared to 5.07% for trust and loan
Economic Council of Canada, The Framework of the Financial System,
Document EC 22-137, 1987.
The bill dealt with financial institutions and amendments to the Deposit
Insurance System Act.
See a list of reports examined by Lang in his study, in Appendix B.
Lang (1990), p. 182.
Appendix C contains a table presenting these estimates.
A.J. Meigs and J.C. Goodman, Federal Deposit Insurance: The Case for
Radical Reform, National Center for Policy Analysis, Policy Report
No. 155, December 1990.
T.F. Cargill and T. Mayer, "U.S. Deposit Insurance Reform,"
Contemporary Policy Issues, Vol. X, July 1992.
K.G. Mantipragada, "Depositors as a Source of Market Discipline,"
The Yale Journal on Regulation, Vol. 9, February 1990.
Cargill and Mayer (1992).
Appendix D contains the proposals as compared by the author.
S. Handfield-Jones, Safeguarding Depositors and Investors: The Role
of Deposit Insurance and Enhanced Supervision, Conference Board of
Canada, Report 56-90-DF.
This regulation went into effect on 31 August 1992.
B. Smith and R.W. White, "The Deposit Insurance System in Canada:
Problems and Proposals for Change," Policy Analysis, Vol. XIV,
No. 4, December 1988.
Canadian Bankers Association, Banking Activities, 1991.
Consumer and Corporate Affairs Canada, "Costs of Using Credit Cards,"