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.
Taxation Papers are written by the staff of the European Commission's Directorate-General for Taxation and Customs Union, or by experts working in association with them. Taxation Papers are intended to increase awareness of the work being done by the staff and to seek comments and suggestions for further analyses. These papers often represent preliminary work, circulated to encourage discussion and comment. Citation and use of such a paper should take into account of its provisional character. The views expressed in the Taxation Papers are solely those of the authors and do not necessarily reflect the views of the European Commission.
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