Compensating victims of bankrupted financial institutions: a law and economic analysis
| Pages | 156-173 |
| DOI | https://doi.org/10.1108/13581981111123861 |
| Published date | 10 May 2011 |
| Date | 10 May 2011 |
| Author | Robert J. Dijkstra,Michael G. Faure |
| Subject Matter | Accounting & finance |
Compensating victims of
bankrupted financial institutions:
a law and economic analysis
Robert J. Dijkstra
Tilburg Institute for Interdisciplinary Studies of Civil Law and
Conflict Resolution Systems (TISCO), Tilburg University, Tilburg,
The Netherlands, and
Michael G. Faure
Maastricht Institute for Transnational Legal Research (METRO),
Maastricht University, Maastricht, The Netherlands
Abstract
Purpose – The purpose of this paper is to understand the incentive effects of existing compensation
mechanisms in case of the bankruptcy of a financial institution.
Design/methodology/approach – The paper uses insights of law and economics to predict the
effects of compensation mechanisms on the incentives of depositors, financial institutions, financial
regulators and government.
Findings – The paper shows that the current compensation system in The Netherlands will not
provide sufficient incentives for all stakeholders to prevent the failure of a financial institution.
Adjustments to this system are necessary to improve these incentives.
Original/value – The paper examines for the first time the impact of different compensation
mechanisms on the incentives of multiple stakeholders. It also shows how these mechanisms influence
each other regarding their incentive generating capability. These findings offer important insights for
policy makers.
Keywords Torts, Compensation,Law, Economics
Paper type Research paper
1. Introduction
The bankruptcy of financial institutions and the manner in which victims are being
compensated is receiving a substantial amount of attention these days. When a financial
institution goes bankrupt, one of the first questions that arises is how will victims of
bankrupted financial institutions be compensated? Of course, the number of potential
victims in the case of bankruptcy of a financial institution is huge. One can think of the
shareholders as primary victims since they will often lose the money they have invested in a
company; other victims are obviously creditors who may not be completely reimbursed by
the proceeds of the bankruptcy proceedings. However, the type of victims we are interested
in, as they constitute the majority of concern for policymakers, are the clients who
simply have put their savings into a bank account, in other words depositors. So, what
are the compensation mechanisms they can rely on if their financial institution goes
bankrupt?
The core of the compensation system is formed through a deposit guarantee system.
Such a mechanism, aiming at the protection (International Association of Deposit
Insurers (IADI), 2009; Groeneveld, 2009) of clients of financial institutions is certainly
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Journal of Financial Regulation and
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pp. 156-173
qEmerald Group Publishing Limited
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DOI 10.1108/13581981111123861
not limited to Europe. Almost all Western countries have such a guarantee system
to maintain stability of the financial system by preventing bank runs. However, despite
the existence of this system, depositors may face losses when their deposits exceed the
guaranteed amount. In these cases, they will have to rely on other instruments to get
compensation for these losses, whereby tort law can be considered the most important
instrument. Since the primary tortfeasor, the bankrupted financial institution, will not
offer significant compensation options, victims will try to hold the financial regulators or
even the government liable. Financial regulators and governments have, compared to
bankrupted financial institutions, deep pockets.
The current structure of this compensation system raises several interesting
questions. First, how does it affect incentives for welfare improving behaviour by all
stakeholders involved? Thus, the question could be asked to what extent the
compensation system affects the incentives of potential clients to choose their financial
institution carefully; the question could equally be asked how the guarantee sys tem is
financed and how does this system subsequently affect the behaviour of financial
institutions and their leading officials? The guarantee system may also affect incentives
of supervisory authorities which merits equal attention. Finally, one might ask how the
different compensation mechanisms influence each other with regard to their incentive
generating capability.
Even though plenty of literature has addressed the deposit guarantee system and its
impact on the behaviour of banks and depositors, none of these papers included its
impact on financial regulators and the government, nor do these papers address other
compensation mechanisms that might be used by victims of bankrupted financial
institutions. This paper aims to address these issues. In order to examine the effect of
compensation mechanisms on the incentives for the various stakeholders, we will use
the insights of law and economics, as this methodology allows us to carefully analyze
how regulation will affect the incentives and behaviour of stakeholders involved, and
what the effects will be on social welfare.
Since deposit guarantee systems exist in many jurisdictions and in different forms,
we will address potential effects of such a deposit guarantee system in a rather abstract
manner; however, we will also focus on the regulation of one particular legal regime to
discuss and analyze how it works in a more detailed way. For that reas on, we have
chosen the deposit guarantee system (in relation to other compensation mechani sms
available) in The Netherlands. We examine to what extent the Dutch compensation
structure provides sufficient incentives for all parties involved in case of bankruptcy of
financial institutions.
Hence, we examine the impact of the current compensation structure on the
behaviour of depositors, financial institutions, financial regulators and government.
The goal of our paper is to provide an economic analysis, using the law and economics
methodology, of the compensation system for victims of bankrupted financial
institutions in The Netherlands. In addition, we expect that the analysis of one particular
legal system will also allow a few general comments on the pros and cons of various
compensation techniques, including a deposit guarantee system.
In addition to this introduction, this paper is divided into five sections. Section 2
describes the compensation structure that currently exists in The Netherlands in more
detail. Section 3 provides an economic analysis of this compensation structure. Using
insights from law and economics, we make predictions with regard to the incentive
Compensating
victims
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