Modelling Deposit Insurance Scheme losses in a Basel 2 framework

This paper adopts an innovative approach for evaluating the adequacy of a Deposit Insurance Schemes (henceforth DIS) funds in a context where banks comply the Basel 2 framework. We estimate DIS loss distributions by means of Monte Carlo simulations, following a methodology that focuses on the part of banks' credit risks non already covered by the Basel 2 capital requirements for banks. We also take account of contagion risk across banks. We argue that existing approaches that assess DIS funds adequacy produce results that do not properly take into account the interaction that exists between the two pillars of banking prudential regulation - deposit insurance and capital requirements - with the consequence a distorted or incoherent assessment of DIS funds adequacy. The model is applied to a sample of Italian banks for 2007. Our results show that the Italian DIS is adequate only in regular times. By contrast, in times of crisis, when firm default rates can suddenly rise substantially above expected and therefore banking defaults tend also to increase, the fund is not fully adequate. Furthermore, our results show the crucial role of contagion risk for the instability of the Italian banking system. The number of defaults registered over 10.000 Monte Carlo simulations, when contagion is accounted for, is 5 times higher than when the model does not control for contagion risk.JRC.G.3-Econometrics and applied statistic