February 2005

This paper examines the potential benefits that the financial system of the Republic of Croatia would derive from introducing risk-based rates of deposit insurance premia for different banks, proportionate to the expected loss to the insurer with respect to an individual bank, the so-called fair premia. In this context, the paper provides a survey of contemporary theory and the worldwide practice of applying risk-based deposit insurance premia. On the basis of the survey of the worldwide practice it is concluded that Croatia has probably not yet attained the level of financial and institutional development that would enable it to obtain the greatest possible benefits of introducing fair premia into the existing deposit insurance system. Furthermore, a simple application of financial theory with a view to introducing a sophisticated fair premium system is impossible in Croatia, as well as in most other countries in the world, due to the lack of necessary market information and unreliability of alternative private information required to accurately determine fair premia. Finally, economic theory warns us that the fair premium is not necessarily also a socially optimal premium, and in certain conditions it is even inferior to the most common alternative - a flat premium rate for all banks. Hence, prior to the introduction of the fair premium it is necessary to examine the potential benefits this change would bring to the specific environment of the Republic of Croatia.

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