Fair premium rate of the deposit insurance system based on banks’ creditworthiness

Purpose: Deposit insurance is a key element in modern banking, as it guarantees the financial safety of deposits at depository financial institutions. It is necessary to have at least a dual fair premium rate system based on creditworthiness of financial institutions, as considering singular premium system for all banks will have moral hazard. This paper aims to develop theoretical and empirical model for calculating dual fair premium rates. Design/methodology/approach: The definition of a fair premium rate in this paper is a rate that covers the operational expenditures of the deposit insuring organization, provides it with sufficient funds to enable it to pay a certain percentage share of deposit amounts to depositors in case of bank default and provides it with sufficient funds as precautionary reserves. To identify and classify healthier and more stable banks, the authors use credit rating methods that use two major dimensional reduction techniques. For forecasting nonperforming loans (NPLs), the authors develop a model that can capture both macro shocks and idiosyncratic shocks to financial institutions in a vector error correction model. Findings: The response of NPLs/loans to macro shocks and idiosyncratic innovations shows that using a model with macro variables only is insufficient, as it is possible that under favorable economic conditions, some banks show negative performance due to bank level reasons such as mismanagement or vice versa. The final results show that deposit insurance premium rate needs to be vary based on banks’ creditworthiness. Originality/value: The results provide interesting insight for financial authorities to set fair deposit insurance premium rate. A high premium rate reduces the capital adequacy of individual financial institutions, which endangers the stability of the financial system; a low premium rate will reduce the security of the financial system.