Assessment and Policy Implications

One lesson of the 1997 financial crisis with regard to the deposit insurance system in Korea is the importance of speedy and decisive reaction of authorities, including the government, financial regulatory and supervisory authorities, and deposit insurers, to restructure failing financial institutions, contain losses, and eliminate the underlying causes that triggered the crisis. 

A greater emphasis should be placed on early detection and warning of potential problems, timely identification of risks, and intervention in failing financial institutions. Since the Depositor Protection Act (DPA) that defines the scope of duties of the KDIC does not include a provision for proactive risk surveillance, the KDIC’s risk surveillance activities have been constrained. 

The deposit insurer should adopt a blanket insurance coverage system during a financial crisis in order to improve and maintain depositors’ confidence and to stabilize the financial system, and then reintroduce a limited coverage system when deemed appropriate. In Korea, limited coverage was changed to blanket coverage to stabilize the financial system and to protect depositors during the financial crisis of 1997. The Korean government reintroduced a limited coverage system in January 2001. 

In order to deal with the shortcomings of the single integrated deposit insurance system, the deposit insurer should differentiate the size of the deposit protection for each financial sector based on idiosyncratic features and varying degrees of risk in each financial sector. Coverage limits are especially important in controlling moral hazards. 

Prompt resolution of failing insured financial institutions can save many depositors and much financial resources of the deposit insurance fund. Forbearance of failing financial institutions would result in a huge increase in the cost of resolving insolvent financial institutions. The deposit insurance agency should be proactive in its resolution planning process to minimize the loss in resolving insolvent financial institutions. In the late 2000s, the KDIC began to participate in the decision process of the resolution method when the FSC decided the resolution method of failed mutual savings banks. 

The deposit insurance agency should endeavor to use the least- cost resolution method to minimize the losses on the deposit insurance fund and thus, the burden on depositors and taxpayers. The Financial Services Commission (FSC) and the Korea Deposit Insurance Corporation (KDIC) have been responsible for conducting the least- cost resolution method in the resolution of failing financial institutions. 

The deposit insurance system should ensure that adequate deposit insurance funds are available to deal with problems as they occur. Adequate deposit insurance funds and public funds, as well as timely funding, are necessary to implement the financial restructuring of the insolvent financial institutions and to protect depositors. A deposit insurance system with a large deficit or insufficient insurance funds would not be able to implement the financial restructuring and to protect depositors. Inadequate funding may lead to a delay in resolving insolvent financial institutions and considerable increase in resolution costs. 

A deposit insurance agency should have powers to implement its mandate efficiently and these powers should be formally specified. In the beginning, the Korean deposit insurance system was a “pay-box system” in view of its role and responsibilities; the KDIC could not implement its responsibilities effectively during the financial restructuring of insolvent financial institutions after the financial crisis. 

The Deposit Protection Act had to be revised several times to support the expanding mandates of the KDIC in order to facilitate the financial restructuring of insolvent financial institutions and to strengthen the financial health of the Deposit Insurance Fund (DIF) after the financial crisis in Korea. 

The deposit insurance agency should be made financially and operationally independent and accountable, and shielded from inappropriate political and industry influence. 
The deposit insurer should implement a risk-based deposit insurance system to mitigate the problem of moral hazard. The risk-based insurance premium system can play a significant role in disciplining the risk-taking behavior of insured financial institutions. It can thereby reduce the burdens which the deposit insurer should bear in lessening the potential losses to the deposit insurance fund. The KDIC is expected to implement a risk-based insurance premium system in 2014. 

The deposit insurer should be given certain instruments that would be available to a private insurer to constrain costs. These include: 1) the ability to promptly stop insurance coverage when a financial institution is operating in a precarious manner, and 2) the authority to examine and assess risk at all insured financial institutions. Since the Depositor Protection Act (DPA) does not give the KDIC such tools, the capabilities to control the KDIC’s costs have been constrained.