Modelling Deposit Insurance Scheme Losses in a Basel

2 Framework
Riccardo De Lisa & Stefano Zedda &
Francesco Vallascas & Francesca Campolongo &
Massimo Marchesi
Received: 11 September 2009 / Revised: 21 October 2010 / Accepted: 22 October 2010 /
Published online: 17 November 2010
#
Springer Science+Business Media, LLC 2010
Abstract This paper extends the existing literature on deposit insurance by proposing a
new approach for the estimation of the loss distribution of a Deposit Insurance Scheme
(DIS) that is based on the Basel 2 regulatory framework. In particular, we generate the
distribution of banks losses following the Basel 2 theoretical approach and focus on the
part of this distribution that is not covered by capital (tail risk). We also refine our approach
by considering two major sources of systemic risks: the correlation between banks assets
and interbank lending contagion. The application of our model to 2007 data for a sample of
Italian banks shows that the target size of the Italian deposit insurance system covers up to
98.96% of its potential losses. Furthermore, it emerges that the introduction of bank
contagion via the interbank lending market could lead to the collapse of the entire Italian
banking system. Our analysis points out that the existing Italian deposit insurance system
can be assessed as adequate only in normal times and not in bad market conditions with
substantial contagion between banks. Overall, we argue that policy makers should explicitly
consider the following when estimating DIS loss distributions: first, the regulatory
framework within which banks operate such as (Basel 2) capital requirements; and, second,
potential sources of systemic risk such as the correlation between banks assets and the risk
of interbank contagion.
J Financ Serv Res (2011) 40:123141
DOI 10.1007/s10693-010-0097-0
The opinions presented here are exclusively those of the authors and do not in any way represent those of the
European Commission.
R. De Lisa (*)
:
S. Zedda
University of Cagliari, Viale S. Ignazio 17, 09124 Cagliari, Italy
e-mail: delisa@unica.it
F. Vallascas
University of Leeds, Leeds, UK
F. Campolongo
European Commission, Joint Research Centre (JRC),
Institute for the Protection and Security of the Citizens, Ispra, Italy
M. Marchesi
European Commission, DG Internal Market and Services, Financial Institutions Directorate, Brussels,
Belgium
Keywords Deposit insurance
.
Basel 2
.
Systemic risk
.
Contagion risk
.
Financial safety net
JEL Classification G21
.
G22
1 Introduction
Deposit insurance schemes (DIS) are set up with the purpose of providing depositors with
the guarantee that their deposits will be (at least in part) repaid whenever a bank defaults.
This guarantee, mainly aimed at preventing bank runs, is a contribution to the stability of
the financial system. To perform this role, a DIS needs to have an adequate amount of funds
at its disposal. Therefore, the estimation of the losses that can affect the deposits of the
insured banks in different market scenarios is a key issue for a DIS and for regulators alike.
The loss distribution of the DIS is, in conclusion, the key piece of information which is
needed to assess the adequacy of its funds,
1
establish a funding target and derive the risk-
based contributions that banks should pay to the DIS.
Despite the relevance of DIS loss distribution for policy decisions, it is striking that,
given the extensive literature on deposit insurance, only a few studies have tried to estimate
it (see Kuritzkes et al. 2005; Sironi et al. 2004). These studies have generally tried to do so
by relying on structural credit risk models and market data to derive banks default
probabilities, and then estimating the losses for the DIS in case of bank failures. This paper
extends these analyses by proposing a new approach to estimating the DIS loss distribution.
To our knowledge the approach we propose is the first that explicitly considers the link that
exists between deposit insurance and the regulatory framework for capital requirements
introduced by Basel 2. This is done in two ways.
First, our approach models the probability of default of a bank as the probability that its
obligors losses exceed actual capital, which is given by its Basel 2 regulatory capital plus
its excess capital, if any. As is well known, in the Basel 2 framework each bank has to
satisfy a capital requirement that provides a buffer against unexpected losses at a specific
level of statistical confidence, set by regulators at 99.9% (Basel Committee on Banking
Supervision 2004, 2005). Therefore, in the Basel 2 regulatory framework the probability
that banks default can be seen as the probability that banks losses fall in the tail of their
loss distribution. This tail risk is equal to 0.1% whenever banks set their amount of
capital at a level equal to their regulatory minimum (Repullo and Suarez 2004) or lower, as
banks normally hold capital well in excess of the regulatory minimum (see, for example,
Jokipii and Milne 2008, 2010; Stolz and Wedow 2009).
Second, we estimate the DIS loss distribution by aggregating individual bank losses
computed according to the Basel 2 FIRB (Foundation Internal Rating Based) formula. To
estimate the default probability of the banks obligors, which is needed in the FIRB
formula, we propose a novel approach that leverages on publicly available regulatory
capital information.
Hence, our model creates an explicit link between the two main pillars of the financial
safety net for banks: capital requirements on the one hand, and deposit insurance schemes
on the other. The relationship between these two safety net tools has been extensively
analysed by a broad theoretical literature (see Santos 2000, for a survey). For instance, the
moral hazard effect created by the establishment of unfairly priced deposit insurance
1
Fund adequacy is analysed as far as its size is concerned. The analysis of contributions arrangements and
the timing of money availability are beyond the scope of this paper.
124 J Financ Serv Res (2011) 40:123141
schemes has generally been identified as one of the main reasons for the introduction of
capital requirements for banks. Furthermore, whenever there are information frictions, the
need to jointly consider the design of deposit insurance and capital requirements has
generally been recognised (Santos 2000). In this paper we propose to go one step further
and require that capital requirements should be explicitly considered in the estimation of the
DIS loss distribution.
Our model also extends the existing literature on deposit insurance by taking into account
how two major sources of systemic risk in the banking system affect the size and shape of the
DIS loss distribution. The first source of systemic risk depends on the existence of a correlation
between banks assets. This correlation may exist as a consequence of banks common
exposure to the same borrower or, more generally, to a particular common influence of the
business cycle. An adverse economic shock may therefore result in simultaneous multiple
defaults on bank loans. The second source of systemic risk depends on the linkages existing
between banks through the interbank lending market (interbank contagion). Hence, our
methodology is closely related to recent models used to quantify the potential for systemic risk
in the financial industry (Elsinger et al. 2006).
Under simplified assumptions, we apply our approach to 2007 data for a sample of
Italian banks in order to assess the adequacy of the Italian DIS funding target. Our results
suggest that the target fund established in 2007 for the Italian DIS can cover up to 98.96%
of its potential losses. Furthermore, while interbank contagion does not produce an overall
shift in the Italian DIS loss distribution, it does cause a large increase in its right tail,
potentially leading to the collapse of the entire Italian banking system. It follows that a
favourable assessment of the adequacy of the existing Italian deposit insurance system must
exclude exceptionally bad market conditions involving substantial contagion between
banks via the interbank lending market. Moreover, the paper underlines the need for
supervisory authorities to treat contagion risk as a key element when assessing the fund
adequacy of a DIS and, more generally, when designing the overall financial safety net.
The rest of this paper is organized as follows. The second section presents a brief review
of the literature, while the third describes our approach to modelling DIS loss distribution in
a Basel 2 framework. The fourth section describes the sample and the variables used in the
analysis, and provides some indications on the characteristics of the Italian DIS. The fifth
section discusses the results of applying our methodology to a sample of Italian banks. The
sixth section sets out conclusions.
2 Literature review
This paper is closely related to the literature that seeks to quantify the DIS loss distribution
and to estimate the optimal size of the DIS funds, knowing banks probabilities of default.
The literature has generally applied two alternative methodologies in order to assess
whether DIS funds are adequate. The first methodology is based on option pricing theory,
originally proposed by Merton (1974) to model risk-based premium in DIS, and later
implemented by Markus and Shaked (1984) and Ronn and Verma (1986). This approach
relies on structural credit risk models to derive the banks probability of default and,
typically, on simulation-based methods to quantify the DIS loss distribution (Kuritzkes et
al. 2005; Sironi et al. 2004). The second methodology, which is less common in the DIS
literature, adopts instead a reduced-form model, drawn from the pricing of fixed-income
securities under default risk, adjusted to be tractable for banks without market debts (Duffie
et al. 2003).
J Financ Serv Res (2011) 40:123141 125
One of the major differences between these two approaches is in the way they define the
event of default. In the structural approach, default is identified as the event occurring when
the market value of the banks assets falls below a certain threshold, generally determined
by the value of the banks liabilities. Conversely, when the reduced form model is used, as
pointed out by Duffie et al. (2003), default is defined as a stopping time the intensity of
which depends on covariates such as leverage, credit rating or macroeconomic conditions.
An application of the first methodology to deposit insurance is provided by Kuritzkes et
al. (2005), for the US context. They quantify the loss distribution faced by the FDIC, by
applying the Merton model to estimate changes in banks credit quality. The loss
distribution is derived through Monte Carlo simulations, where the changes in the PD are a
function of a systematic risk factor (dependent on macro variables) and of a bank-specific
idiosyncratic component. Their results suggest that the FDIC reserves are sufficient to cover
99.85% of the loss distribution related to the funds 8,571 member banks.
Sironi et al. (2004) apply a somewhat similar approach to the 15 largest Italian listed
banks. Their estimated loss distribution makes it possible to quantify the loss rate for every
possible confidence interval and a multiplier that, when applied to the unexpected loss,
computes the loss corresponding to the desired confidence interval. Their study highlights
that, while the most risky banks give a greater contribution in terms of expected loss, the
larger banks make the greater contribution in terms of unexpected loss. As a result, the
difference between an insurance premium based only on expected loss and one built on
unexpected loss can be substantial for banks that represent the larger exposures.
Unlike Kuritzkes et al. (2005) and Sironi et al. (2004), Dev et al. (2006) propose a
structural model for deposit insurance premia that is characterised by an analytical solution
rather than obtained by means of a simulation-based approach. Their modelling framework
explicitly takes into account the liability structure of banks, by distinguishing insured and
uninsured deposits from senior secured debts, and introduces the correlation between PD
and LGD as a determinant of deposit insurance premia.
2
Duffie et al. (2003) present an application of reduced form models to DIS, inspired by the
pricing of fixed-income securities subject to default risk. The fair-market insurance rate for a
given bank is approximated as the banks short term credit spread times the ratio of the
insurer expected loss at failure per dollar of insured deposits to the bond investors expected
loss at failure per dollar of principal. Furthermore, to overcome the possibility that financial
institutions do not present market debts in their capital structure, Duffie et al. (2003) propose
an alternative methodology based on a logit model of the banks default probability.
A further different approach has been proposed by Jarrowet al. (2006) that focus instead on
the computation of countercyclical risk premium by modelling the unconditional distribution
of the loss events, the asset size of the failing banks and the loss rate for the DIS in the case of
bank defaults. In such a framework, the number of failures is derived by simulation, based on
the historical failure experience of the FDIC. Their analysis suggests that any countercyclical
policy is not costless. By contrast, a countercyclical rebate system produces an increase in the
aggregate premium of about $9 billion over a period of 10 years.
Summing up, the existing literature that seeks to estimate the DIS loss distribution is
mainly based on structural models for credit risk, which generally require market data in
order to empirically apply the proposed methodology. This literature shows no sign of
2
A further extension of the traditional option pricing approach is provided by Episcopos (2004), who applies
the concept of vulnerable option to deposit insurance. With respect to the more commonly applied option
framework, this extension takes into account not only the relevance of the each banks risks, but also the risks
of the guarantor. However, in contrast to the analyses described above, this approach does not require the
derivation of any loss distribution in order to set DIS funds.
126 J Financ Serv Res (2011) 40:123141
considering any link between banks capital requirements and the shape and size of the DIS
loss distribution. As is fully explained in the following section, our approach differs from
the existing literature in two major respects.
First, we estimate the DIS loss distribution on the basis of a framework that explicitly links
two main pillars of the financial safety net, namely banks capital requirements and deposit
insurance. More specifically, and unlike previous studies, we model the banks default probability
as a tail risk (Repullo and Suarez 2004) that reflects bank capital strength and asset quality. To
this end, we postulate that default takes place for each bank when the amount of its asset losses
exceeds the banks capital requirements plus (if applicable) the banks excess capital.
Hence, given that under the Basel 2 accord capital requirements provide a buffer against
unexpected losses at a level of statistical confidence set by regulators at 99.9%, whenever
banks fix the amount of capital at the regulatory minimum they share the same probability
of default equal to 0.1% (Repullo and Suarez 2004). However, banks normally hold capital
well in excess of this minimum regulatory amount (see for example Jokipii and Milne 2008,
2010; Stolz and Wedow 2009). As a result, they also show different (lower than 0.1%)
probabilities of default. On the basis of these default probabilities for banks, we design the
losses stemming from banks and affecting the DIS, by using the Basel 2 FIRB formula.
Second, we explicitly take into account the impact of systemic risk that, as in DeBandt
and Hartmann (2000), we assume as being generated by two different sources. The first
source of systemic risk depends on the fact that banks have correlated assets, and thus that
an economic shock has consequences for the financial system and the broader economy,
simultaneously impacting a number of banks. The second source of systemic risk depends
instead on the linkages between banks produced by the interbank lending market that can
produce a default domino effect across the banking system (interbank contagion).
The relative importance of these two sources of systemic risk is assessed by Elsinger et
al. (2006) in an analysis aimed at evaluating the potential for systemic risk in the Austrian
banking industry. Their conclusion is that correlated portfolio exposures of banks are the
major source of systemic risk, while contagion via the interbank lending market seems to be
a rare event. Contrary to our analysis, the authors do not investigate the implications of their
model for deposit insurance schemes, but focus instead on the consequences for a lender of
last resort of these two channels of systemic risk.
3 Methodology
We estimate the loss distribution of a DIS in a simplified banking system where banks are
exposed only to credit risk and are fully compliant with the FIRB Basel 2 minimum capital
requirements. The analysis follows the steps summarised by Fig. 1.
Step 1: Define the default point
We start by defining when a bank defaults in a Basel 2 framework. More
specifically, the new capital accord uses the Vasicek (see Vasicek 1987, 1991,
2002; and Gordy 2003) model to compute, for each obligor of the bank, its Value
at Risk (VaR), which is the loss amount that is not expected to be exceeded within
a given confidence level and within a defined time horizon.
3
As banks are generally expected to cover their Expected Losses (EL) on an
ongoing basis, i.e. by provisions and write-offs, Basel 2 requires banks to hold
3
See Appendix for details.
J Financ Serv Res (2011) 40:123141 127
capital only to cover Unexpected Losses (UL). Therefore, as shown in Fig. 2 (and
in accordance with the Basel 2 framework), we assume that a bank j defaults
when obligor portfolio losses (L) exceed the sum of the expected losses (EL) and
the total actual capital (CAP) given by the sum of its capital requirements plus the
banks excess capital (if any); namely, when the following condition is satisfied:
L
j
> EL
j
CAP
j
1
As detailed in the following section, we model the losses generated by the bank
portfolio (L
j
) as a function of the creditworthiness of bank obligors. Thus, banks that
hold the same amount of assets differ in their likelihood of failure when the risk of
default of their obligors differs.
4
However, this is not the only factor that determines
differences in the risk of default across banks under the condition indicated by Eq. 1.
More precisely, banks that show both an identical size and quality of the asset
portfolio, may still show differences in default risk if they hold a different amount of
capital (CAP
j
). In turn, this implies that bank default risk is a function of a banks
capital strength.
5
Overall, the condition in Eq. 1 implies that the obligor credit quality and the bank
capital strength are the two bank characteristics that have a direct influence on the
bank default event.
Step 2: Generate via Monte Carlo a sample of correlated banks asset losses
According to Eq. 1, one of the key variables to identify when a bank defaults is
the amount of asset losses. We quantify this amount via a Monte Carlo simulation.
4
The credit quality of the asset portfolio influences also the value of the expected losses (EL
j
): banks with
more risky assets will show higher values of EL
j
.
5
This can be clearly understood by dividing both members in Eq. 1 by total assets. Under this new
specification, a lower risk of default is associated to a higher bank capital ratio (the ratio between equity
capital and total assets).
STEP 1
Define the default point
STEP 2
Generate via Monte Carlo a sample of correlated
bank's losses
STEP 3 Check which banks fail
STEP 4 Include interbank contagion risk
STEP 5
Derive the DIS loss distribution
Fig. 1 Steps of the analysis
128 J Financ Serv Res (2011) 40:123141
We simulate a sample of banks losses L
ij
, for each bank j, and for each simulation
i =1,...,n, in the form of a (n k) matrix, where n is the total number of
simulations and k is the total number of banks in the system. The sample is
generated using the same distribution for banks losses as used by Basel 2 in the
FIRB approach. In particular, if we denote by the probability of the loss being
less than or equal to a certain amount x, we have:
a PfL xg N

1 R
p
N
1
x N
1
PD

R
p
_ _
2
where N is the normal cumulative density function, and R is the common pairwise
correlation between obligors, specified as in Basel 2.
With some algebra, we can express the loss x as a function of the probability
:
x N

R
p
N
1
a N
1
PD

1 R
p
_ _
3
In our model, denoting by L
ij
the i
th
realization of the maximum loss for bank j
given a certain random value of probability
ij
, by PD
j
the average probability of
default of the asset portfolio of bank j, and by LGD the Loss Given Default,
formula Eq. 3 reads:
L
ij
LGD N

1
1 R
_
N
1
PD
j

R
1 R
_
N
1
a
ij

_ _
4
Assuming LGD 1, a sample of losses L
ij
is generated via random shocks for
N
1
(), which is assumed to be normally distributed. The assumption of normal
Bank fails
Losses
Pr
Bank's losses distribution
Capital requir. + Excess cap. Deposit insurance
Provisions
Expected loss
Fig. 2 Tail risk, Basel 2 and deposit insurance
J Financ Serv Res (2011) 40:123141 129
distribution is needed in order to reproduce the distribution of banks losses which
is implied in Basel 2.
To estimate the values of PDs needed in Eq. 4, we adopt a novel approach
that is consistent with the Basel 2 regulatory framework. In particular, we
compute a proxy of the quality of a bank obligor portfolio by inverting the Basel
2 FIRB capital requirement formula as described in Appendix. This can be done
as the PD of a bank obligor is the only unknown variable: the capital
requirement is known, and all other variables in the formula can be set to their
regulatory values.
The resulting estimate PD

j
, hereafter ImpliedObligorPD, represents a proxy
of the average default probability of the obligor portfolio of bank j.
Within this general framework, the model takes account of a first source of
systemic risk, as banks have correlated exposures. This correlation exists
either as a consequence of the banks common exposure to the same borrower
or, more generally, to a particular common influence of the business cycle. We
model the impact of this macroeconomic source of systemic risk by generating
a correlated random shock on the basis of a correlation matrix among banks
assets.
Initially, for the sake of simplicity we assume that banks share the same value
of asset correlation. Specifically, Sironi et al. (2004) found that the average asset
correlation for a sample of Italian banks is around 50%. Hence, we use this
value as initial input in our model. However, the assumption of a constant
correlation across banks leaves out some firm heterogeneity and can influence
the estimation of the DIS loss distribution.
6
Therefore, we elaborate further on
this point in the robustness section, where we consider alternative specifications
of the correlation matrix.
Step 3: Check which banks fail
Once a sample of banks losses has been generated, these losses are used to
determine which banks fail in each simulation. In particular, we check which banks
fail according to the condition established by Eq. 1 and create, from a (n k) matrix
of losses, a matrix of failures which is a (n k) matrix of zeros (no failure) and ones
(failure).
Step 4: Include interbank contagion risk.
Next, we introduce into the model a second source of systemic risk, defined as
the risk of contagion between banks though the interbank lending market. When a
bank fails, its losses actually affect both the banks (insured) deposits and the
interbank creditors,
7
and we must consider that a bank may also fail because the
losses produced through the interbank market have triggered a domino effect on
other banks.
We model the contagion across k banks (of which j failed) by assuming a
proportional distribution of the interbank losses of a defaulted banks to the
remaining interbank creditor banks. For instance, if bank j fails, we assume that
the losses that bank j passes to the remaining bank h are proportional to the credit
7
When a bank fails, we consider that the creditors in the interbank market are facing a liquidity risk. This
liquidity risk is equal to the total amount of interbank credits that the other banks have lent to the defaulted
bank.
6
We thank an anonymous referee for raising the issue of the relevance of considering firm heterogeneity
when we model credit risk. On this aspect see Hanson et al. (2008).
130 J Financ Serv Res (2011) 40:123141
share of bank h in the interbank market. The loss incurred by bank h can then be
written as follows:
IBloss
h
j IB

j
IB

k6j
IB

k
5
where IB

j
is the debt exposure of bank j in the interbank market and IB

h
is the
creditor exposure of bank h in the same market. The total loss of bank h due to the
interbank contagion effect is obtained as:
IBloss
h

j
IB

j
IB

k6j
IB

k
6
Then, the resulting loss of bank h will be given by the sum of the losses of its
loan portfolio plus the losses suffered via the interbank market exposures.
Once the matrix of bank losses has been completed, we check whether other
banks fail due to the contagion effect. We repeat the procedure until no additional
bank failure is produced, and build the final bank failure matrix. Notably, by
modeling bank contagion, we introduce further elements of heterogeneity across
banks as the banks default risk will now also depend on a bank net position in
the interbank market.
Step 5: Derive the DIS loss distribution
The empirical DIS loss distribution is obtained as follows. For each simulated
scenario we look at which banks fail and transfer to the DIS the total amount of its
deposits. This, once again, corresponds to addressing a liquidity problem where we
assume that the total loss of a defaulted bank is equal to its total liabilities (deposits).
It is worth noting that the model can also be used to derive a proxy of the banks
PD, namely BankPD (to be distinguished from its portfolio average PD,
ImpliedObligorPD). This is derived as the ratio of the number of times a bank
fails over the total number of simulated scenarios. Note that the BankPD results from
the interaction between its asset quality (ImpliedObligorPD) and its capital strength.
4 Sample, variables of the analysis and main characteristics of the Italian DIS
The model described in the previous section has been applied to unconsolidated accounting
data for a sample of 494 Italian banks for year 2007. Data are drawn from the ABIBANK
dataset managed by the Italian Banking Association (ABI). The variables employed in the
analysis are summarized in Table 1, where we show some basic descriptive statistics.
ABIBANK dataset ensures a proper coverage of the entire Italian banking system.
According to the statistics provided by Bank of Italy, our sample accounts in fact for around
70% of the total DIS eligible deposits.
8
8
As our approach models only credit risk, it is worthwhile to analyse how relevant this risk is in our sample.
To this end, we examine the distribution of the weights of the credit risk capital requirements over the total
capital requirements for each bank. We observe a mean value of over 91% (st. dev. of 18%). The credit risk
therefore is the most important source of regulatory risk in our sample.
J Financ Serv Res (2011) 40:123141 131
The banks selected in our sample are covered by the safety net arrangement provided by
the Italian deposit insurance system, which consists of two schemes. The first is the Fondo
Interbancario di Tutela dei Depositi (FITD), established in 1987 as a voluntary consortium,
and which is now a private mandatory consortium recognised by the Bank of Italy. The
second is the Fondo di Garanzia per le Banche di Credito Cooperativo, established in 1997
for co-operative banks operating in Italy.
Both schemes are based on an ex-post contribution system and on a deposit coverage
level per depositor of 103,291 . The overall contribution to the DIS by insured banks
ranges between 0.4% (floor) and 0.8% (target size) of the insured deposits. For 2007, the
Italian system had an overall contribution minimum floor of 1,602 m and a target size of
3,204 m for total insured deposits of more than 400 bn.
5 Results
This section summarizes and discusses the empirical results obtained. First, we present
some basic statistics on the banks risk measures. Then, we discuss the estimation of the
DIS loss distribution and assess the adequacy of the Italian DIS.
5.1 Banks ImpliedObligorPDs and BankPDs
Table 2 presents summary statistics for the two risk measures that have been estimated to
build the DIS loss distribution. The first risk measure is the average default probability of
the obligor portfolio of each bank (ImpliedObligorPd), calculated by inverting the Basel 2
FIRB formula (See #3) and employed to compute asset losses.
9
The second measure is the
BankPD that represents the probability of default of each bank and capturing the probability
of a banks losses falling in the tail of its loss distribution not covered by its actual capital.
Both the average and median ImpliedObligorPD of the Italian banks are equal to 0.44%.
This value is roughly equivalent to an average borrower A rating. Overall, we observe some
9
Since the capital requirements disclosed by the Italian banks in 2007 still refer to the rules established by
Basel I, our estimates assume that the regulatory shift due to the adoption of an FIRB approach does not
modify these requirements. Although we acknowledge the simplifications behind this assumption, it is worth
emphasising that one of the purposes that the new regulatory framework is to avoid substantial changes in the
capital requirements applied to banks (Cannata and Quagliariello 2009).
Table 1 Summary statistics. This table reports descriptive statistics for our sample of 494 Italian banks for
2007. This sample represents around 70% in terms of total DIS eligible deposits. Amounts are in m
Definition N Mean Median St.Dev. Min Max Total
TA Total assets 494 2,934 329 19,785 6 394,869 1,449,552
DEP Customers deposits (currents
accounts, demand deposits,
restricted deposits)
494 1,104 141 6,175 2 113,541 545,562
(381,893)
a
IB
+
Banks deposits (due from banks) 494 570 20 4,991 0.9 100,832 281,554
IB

Banks deposits (due to banks) 494 414 2 4,113 0 86,008 204,689

KREQ Regulatory capital requirements
(8% Risk weighted assets)
494 160 17 1,066 0,94 21,615 78,870
a
Insured deposits
132 J Financ Serv Res (2011) 40:123141
heterogeneity in the quality of the bank portfolio in our sample, as shown by the large gap
between the minimum and maximum values of the ImpliedObligorPD.
Moving on to the analysis of the BankPDs, from Panel A of Table 2 we see that the
average (median) value of the probability for banks to default is, in the absence of interbank
contagion, equal to 0.02% (0.01%) with values up to 0.1%. This latter result is not
surprising given the 99.9% confidence interval of the Basel 2 capital requirements
regulation that leads to a maximum tail risk of 0.1% for all banks. However, as summarized
in Panel B, when we consider the influence of the interbank contagion channel, the
distribution of banks PDs shows an increase of the mean (median) to round 0.029%
(0.017%), while the maximum increases to 0.2%.
Regarding the determinants of the degree of heterogeneity of the ImpliedObligorPDs
and BankPDs, Table 3 reports the correlation coefficients between these two risk measures
and selected bank characteristics: bank size (expressed as the log of total assets) and the
ratio between bank capital and its minimum capital requirement. This latter variable
represents the bank excess capitalisation rate.
Table 2 Summary statistics of ImpliedObligorPDs and BankPDs. This table shows statistics of PDs
estimates. ImpliedObligorPDs represents the average PDs of the obligors portfolio of sample banks.
BankPDs are the default rates of the sample banks in the simulations time horizon. In details, Panel A shows
summary statistics of BankPDs in the case of no interbank contagion. Panel B presents the same statistics
when simulations consider the impact of interbank contagion. We employ a sample of 494 Italian banks;
accounting data refer to 2007
ImpliedObligorPD (%) BankPD (%)
Panel A: Without
interbank contagion
Panel B: With
interbank contagion
Mean 0.4391 0.0202 0.0289
Std. deviation 0.1998 0.0267 0.0341
Minimum 0.0040 0.0000 0.0000
Maximum 2.0670 0.1086 0.2034
Percentiles: 25% 0.3130 0.0018 0.0058
50% 0.4355 0.0097 0.0168
75% 0.5670 0.0281 0.0373
Table 3 Correlation matrix. This table shows bivariate correlation between PDs estimates and some banks
main characteristics. ImpliedObligorPDs represents the average PDs of the obligors portfolio of sample
banks. BankPDs are the default rates of the sample banks in the simulations time horizon. Excess capital
represents the ratio between the total capital over capital requirements. We employ a sample of 494 Italian
Banks. Accounting data refer to 2007
ImpliedObligorPD BankPD
(without interbank)
BankPD
(with interbank)
Excess capital
BankPD (without interbank) 0.371** (0.000)
BankPD (with interbank) 0.186** (0.000) 0.901** (0.000)
Excess capital 0.494** (0.000) 0.333** (0.000) 0.302** (0.000)
Log of total assets 0.253** (0.000) 0.465** (0.000) 0.483** (0.000) 0.277** (0.000)
**: Correlation is significant at the 1% level; p-value in round brackets
J Financ Serv Res (2011) 40:123141 133
This Table suggests two major considerations. First, as expected, the ImpliedObligorPDs
and BankPDs show a positive and significant correlation. However, this correlation is far
from being a signal of a perfect linear association between ImpliedObligorPDs and BankPDs
(r=0.37/0.19 without and with interbank contagion). This result is therefore consistent with
the effect on banks probability of default under Basel 2 capital requirements.
Second, the correlation coefficients of ImpliedObligorPDs and BankPDs with bank
characteristics are highly significant and show the same signs: both risk measures are
positively related to bank size and negatively related to bank excess capitalisation rate.
It is also significant that the excess capitalisation rate shows a correlation of only 0.33/0.30,
without and with interbank contagion with BankPDs respectively. These values are much lower
than expected, due to the role of excess capital in our definition of the bank default point.
However, a linear correlation does not seem to properly describe the relationship between
BankPDs and excess capitalisation rate. This emerges clearly from Fig. 3 where we plot the
values of BankPDs computed with and without interbank contagion, versus the ratio between
bank capital and minimum capital requirements. This figure confirms the negative (but not
linear) relationship between the two variables: therefore, larger values of the excess
capitalisation ratio substantially reduce the BankPD. This figure also confirms the influence
of interbank contagion on BankPDs: when the number of failures produced by the domino
effect generated in the interbank market is taken into account, we observe a clear upward shift
in the distribution of our tail risk indicator. However, the BankPDs are still negatively related
to the excess capitalisation ratio. Overall the BankPDs seem to effectively summarize the effect
of both obligors credit quality and capital strength on the risk of default by a bank.
5.2 The loss distribution of the Italian DIS
Table 4 shows the estimates of the Italian DIS loss distribution for different values of
banks asset correlation. As presented in Section 3, we start by setting the asset correlation
Total capital over total capital requirements
19. 48
4.53
3.24
2.74
2.37
2.15
1.97
1.78
1.67
1.55
1.46
1.36
1.22
1.09
1.00
B
a
n
k
P
D
(
%
)
.3
.2
.1
0.0
Without Contagion
With Contagion
Fig. 3 BankPDs vs Excess
Capital. Banks correlation factor
is set at 50%
134 J Financ Serv Res (2011) 40:123141
to the average value (50%) estimated in Sironi et al. (2004) for Italian banks. Further, to
assess the sensitivity of our results to the value of the correlation factor, we repeat the
calculations by setting its value at 30% and 70%. These two values roughly correspond to
the mean minus/plus one standard deviation according to the results reported in Sironi et al.
(2004).
We set the number of simulations at 500,000 in order to have a broad sample of defaults.
We start by modelling the loss distribution assuming no contagion via the interbank
market. The results of this analysis, reported in Panel A of Table 4, show that the average
loss of the DIS is quite small regardless of the value assigned to the correlation factor.
Furthermore, the distribution is characterised by very large losses, i.e. ten times the DIS
target size, that occur in rare, but not negligible, cases (greater than 0.1%). As the value of
the correlation increases, there is a sort of clustering effect of banks defaults: the number of
bank defaults becomes larger and concentrated in fewer scenarios.
In Panel B of Table 4 we repeat our simulation with an assumption of contagion via the
interbank market. We observe an increase in the expected loss of the distribution. For
instance, in the case of a 50% correlation factor, the average loss rises from 164 to 251 m.
However, this increase does not signify an overall shift in the distribution, but reflects an
increase in the loss values that can affect the DIS in extreme market scenarios, possibly
leading to the collapse of the banking system (see also Fig. 4). Our findings are consistent
Table 4 DIS loss distribution for different values of the banks common correlation factor. N. of default
scenarios represents the number of scenarios (over 500,000 simulations) with at least one banks default.
Panel A shows summary statistics of the DIS loss distribution under the assumption of no interbank
contagion. Panel B presents the same statistics when the simulations consider the impact of interbank
contagion. We employ a sample of 494 Italian Banks. Accounting data refer to 2007 and amounts are in m
Banks correlation factor
30% 50% 70%
N. of default scenarios 30,685 19,180 9,883
Panel A: without interbank contagion
Mean 164 164 166
St. Dev. 1,760 2,114 2,906
Percentile:
97,00% 417 149
99.00% 4.072 3,397 1,513
99.90% 32,990 33,193 39,198
99.99% 47,939 76,925 117,189
100.00% 106,755 234,121 335,337
Panel B: with interbank contagion
Mean 192 251 391
St. Dev. 2,863 4,991 8,769
Percentile:
97,00% 417 149
99.00% 4,213 3,427 1,513
99.90% 32,990 42,241 120,780
99.99% 106,251 298,053 343,360
100.00% 299,034 350,358 373,063
J Financ Serv Res (2011) 40:123141 135
with those of Elsinger et al. (2006) and Furfine (2003) who show that the domino effect
between banks is actually a rare event in Austria and the US.
Overall, our analysis shows that, in a Basel 2 framework, the losses for the Italian DIS
are relatively small up to the 99th percentile, even though there is a risk of very large losses
under very negative market conditions, especially when interbank contagion is considered.
5.3 The adequacy of the Italian DIS
We now use our model to assess the adequacy of the Italian deposit insurance system. Since
in 2007 the Italian system had a minimum floor of 1,602 m and a target size of 3,204 m,
the results reported in Table 4 show that the Italian DIS is currently able to cope with
almost 99% of the potential losses (minimum floor: 98.58%; target size: 98.96%) with and
without interbank contagion in the case of 50% correlation (see Fig. 5).
This result tends somehow to be affected by changes in the correlation factor. With the
30% correlation case, the percentage of losses with which the Italian DIS is able to cope
marginally declines (minimum floor: 98.28%; target size: 98.81%), while with the 70%
correlation the percentage tends to rise (minimum floor: 99.02%; target size: 99.23%).
.
9
7
.
9
8
.
9
9
1
C
u
m
u
l
a
t
i
v
e

f
r
e
q
u
e
n
c
y
0 100,000 200,000 300,000 400,000
Losses (m)
Without interbank contagion With interbank contagion
Fig. 4 DIS loss distribution, with
and without interbank
contagion. Banks correlation
factor is set at 50%
Italian DIS target size (3,204 m)
.
9
7
.
9
8
.
9
9
1
C
u
m
u
l
a
t
i
v
e

f
r
e
q
u
e
n
c
y
0 100,000 200,000 300,000 400,000
Losses (m)
Without interbank contagion With interbank contagion
Fig. 5 Italian DIS fund adequa-
cy. Banks correlation factor is
set at 50%
136 J Financ Serv Res (2011) 40:123141
Overall, the Italian DIS appears to be adequate to cover the large majority of its potential
losses. However, it is still exposed to an unsustainable amount of losses under extreme market
conditions, leading to the overall collapse of the financial system. Our results are therefore largely
consistent with the findings of Kuritzkes et al. (2005) for the US deposit insurance scheme.
5.4 Stress and robustness tests
In this section we test the sensitivity of our findings when we change some key underlying
assumptions. First, we perform a stress test to assess the impact on the loss distribution entailed
by an increase in the level of riskiness of the bank portfolio of obligors. Accordingly, we modify
our proxy of the quality of the asset portfolios (ImpliedObligorPDs), as in times of crisis it is
likely to become suddenly much higher than usual before any capital adjustment.
Then, we perform a robustness test with respect to the assumption that assets correlation
is constant between banks.
The stress testing is performed according to two scenarios. The first involves
ImpliedObligorPDs which, on average, become twice as high compared to the initial
condition, while the second scenario focuses on a more extreme market condition, with
ImpliedObligorPDs that become (on average) five times higher than the initial value. It is
worth pointing out that, in order to introduce an element of heterogeneity in the data, the
change in ImpliedObligorPDs is not equal for each bank in the sample.
10
The values of the
ImpliedObligorPDs have been randomly perturbed with the result that the average value of
their distribution either doubles or becomes five time higher. For the sake of simplicity, we
report only the results of the loss distribution for the 50% correlation scenario.
The results of this sensitivity test are reported in columns 3 and 4 of Table 5. Panels A
and B report results, without and with contagion, respectively. As expected, the loss
distribution shows a relevant increase in the amount of losses as the level of riskiness of the
banks obligor portfolio rises, although the effect tends to be concentrated in the tail of the
distribution. In the case of double ImpliedObligorPDs, our findings still support the
conclusion that the Italian DIS is adequate in the large majority of the market scenarios: the
fund (target size) is still able to cover 97.0% of the loss distribution (98.96%, in the basic
scenario). This result is confirmed both with and without the effect of interbank contagion.
However, when we consider the more severe event where the quality of the bank
portfolio becomes five times worse, the Italian DIS becomes inadequate: with the interbank
contagion, the existing target only covers up to 90.53% of the potential losses. It is worth
noting that the importance of interbank contagion increases as the asset riskiness becomes
higher. This appears to be reasonable: as the quality of banking portfolios decreases there
should be an increase in the number of defaults, leading to a larger amount of losses
transmitted via the interbank contagion channel.
Moving on to the robustness checks, we test the effects of relaxing the assumption of
constant asset correlations between banks according to two scenarios. In the first case, we
assume that the correlation is normally distributed across the sample of banks maintaining
the same mean of the basic scenario (50%).
In the second scenario, we model the correlations between banks assets as being size
dependent,
11
by imposing a higher correlation between larger banks. This choice is
10
We thank an anonymous referee for suggesting this testing approach.
11
Banks are split in three size-based buckets (total assets): up to 1,000 m; larger than 1,000 and up to
10,000 m; over 10,000 m. Buckets are chosen in order to achieve a balance between the number of banks
in each bucket and the share of total assets it represents.
J Financ Serv Res (2011) 40:123141 137
motivated by recent studies that demonstrate how large banks are normally characterized by
a larger share of common sources of shocks while benefiting from lower levels of
idiosyncratic risk (see Baele et al. 2007, for Europe, and Schuermann and Stiroh 2006, for
the case of US).
12
In a similar vein, De Jonghe (2010) shows that large banks are more exposed to common
sources of tail risks and Huang et al. (2010) indentify bank size as the major determinant of
systemic risk contribution. From a theoretical perspective these latter results might be
explained by the high degree of diversification typically shown by large banks. For
instance, Wagner (2010) proposes a theoretical model where diversification increases
similarities between financial institutions leading to an increase in the correlation of their
asset risk.
These tests show that there is no significant impact on the loss distribution when
correlation is randomly drawn from a normal distribution. On the contrary, when the
correlation is simulated considering banks size buckets, the 99th percentile tends to
decline due to higher clustering effects of bank losses. In other words, the increase in
the asset correlation between large banks, as compared to the baseline simulation based
on a value of bank correlation fixed to 50%, leads to an increase in the concentration of
Table 5 Sensitivity of the DIS loss distribution to ImpliedObligorPD and banks asset correlation changes.
Panels A and B show summary statistics of the sensitivity tests conducted on the DIS loss distribution,
respectively without and with interbank contagion. We employ a sample of 494 Italian Banks. Accounting
data refer to 2007 and amounts are in m
Basic Scenario ImpliedObligorPD changes Correlation distribution Changes
PD 2 PD 5 Normally distributed Banks size driven
(1) (2) (3) (4) (5) (6)
Panel A: without interbank contagion
Mean 164 609 2,004 164 165
St. Dev. 2,114 4,637 9,252 2,195 2,656
Percentile:
97,00% 149 3,089 26,824 154 176
99,00% 3,397 24,089 43,762 3,397 1,984
99.90% 33,193 60,961 105,604 33,405 37,685
99.99% 76,925 119,667 183,329 79,649 100,662
100.00% 234,121 369,307 332,846 262,088 298,392
Panel B: with interbank contagion
Mean 251 1,002 3,856 268 361
St. Dev. 4,991 10,648 23,713 5,430 7,944
Percentile:
97,00% 149 3,143 33,251 154 176
99,00% 3,427 32,990 102,722 3,397 1,984
99.90% 42,241 163,811 326,748 49,245 100,456
99.99% 298,053 330,938 350,387 302,525 323,806
100.00% 350,358 359776 369,633 351,297 345,308
12
Also in this second test we assume the mean of the correlation distribution to be equal to that of the basic
scenario.
138 J Financ Serv Res (2011) 40:123141
large losses in the extreme tail of the distribution as the number of failures of (large)
banks tends to be concentrated in fewer scenarios. Notably, both robustness checks
based on the adjustment of the correlation factor, suggest that the Italian DIS is more
than adequate.
Overall, these tests highlight the importance of market conditions in assessing the fund
adequacy of a DIS. Further, these tests also show that the adoption of alternative
approaches to model the correlation factor does not substantially change the conclusions on
the adequacy of the Italian DIS.
6 Conclusions
This paper extends the existing literature on deposit insurance by proposing a new approach
for the estimation of the loss distribution of a DIS. More specifically, we adopt a
methodology that is based on the Basel 2 regulatory framework for capital requirements
and where two sources of systemic risk are considered.
Our approach is built upon the Basel 2 framework in two ways. First, we consider a
probability of default for banks, which is defined as the probability that their losses exceed
their capital requirements under Basel 2 plus their excess capital, if any. As a consequence,
our DIS loss distributionestimated via Monte Carlo simulationsis based on the
identification of those banks that default because their unexpected losses are in excess of
their total capital. Secondly, our approach is based on an estimate of the banks losses
according to the Basel 2 FIRB formula, where a proxy of the average default probability of
the bank obligors portfolio is estimated on the basis of publicly available regulatory capital
information.
The application of our model to a sample of Italian banks for 2007 data shows that, in
the Basel 2 framework, the Italian DIS can cover up to 98.96% of its potential losses. Once
considered, interbank contagion does not produce an overall shift in the Italian DIS loss
distribution, but it does cause a large increase in its right tail. This may result in the collapse
of the entire Italian banking system.
In conclusion, the main effect of interbank contagion is to increase substantially the
unexpected losses for the DIS in the most extreme market scenarios.
As a consequence, the existing Italian deposit insurance system can be considered as
adequately funded, except where extremely bad market conditions prevail.
Overall, we argue that the DIS loss distribution should be assessed by taking into
appropriate consideration the (Basel 2) regulatory framework based on capital requirements
within which banks operate. Furthermore, our analysis suggests that the DIS fund adequacy
can be sensitive to extreme market conditions.
The paper also shows the need to consider interbank contagion as a key element when
designing the overall financial safety net.
Acknowledgments We are grateful to Ed Altman, J. Dermine and an anonymous reviewer for helpful
comments on an earlier draft of this paper.
Appendix
The computation of capital requirements in the Basel 2 Internal Ratings-Based (IRB)
approach
J Financ Serv Res (2011) 40:123141 139
In the IRB approach, the capital requirement (CR) for a single exposure is computed
according to the following formula:
CR LGD N

1
1 R
_
N
1
PD

R
1 R
_
N
1
0:999
_ _
PD LGD
_ _
1 1:5 B
1
1 M 2:5 B 1:06 1
Where:
PD is the obligor probability of default;
LGD is the loss given default;
M is the time to maturity;
B is a function of PD computed as B 0:11852 0:05478 ln PD
2
)
R is the correlation factor computed as follows:
R 0:12
1 EXP 50 PD
1 EXP 50
0:24 1
1 EXP 50 PD
1 EXP 50
_ _
0:04 1
S 5
45
_ _
2
where S is the size of the firm.
Given the assumption of infinite granularity, the overall capital requirement for a bank j
is computed as the sum of the capital requirements of each loan exposure l:
K
j

l
CR PD
l
A
l
3
that is the sum of the capital allocation parameter (CR) of each exposure l multiplied by its
amount Al.
We can derive the average PD of a banks asset portfolio needed to compute the asset
losses as
PD

j
CR PD

j
_ _

l
A
l

K
j
4
where Kj is the total value of the capital requirements for the bank j.
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