(Reprinted from HKCER Letters, Vol.13, March 1992)
A Deposit Protection Scheme
for Hong Kong?
The Consultation Paper on the Deposit Protection Scheme (DPS) put forth by the Monetary Affairs Branch last February starts with the discussion of the pros and cons of such a scheme. It correctly acknowledges that there are certain limitations on the functioning of a DPS, yet it goes on to point out that a DPS could serve three purposes, especially in view of the recent BCCHK debacle; namely, the protection of small depositors, the enhancement of stability, and the enhancement of competitive efficiency in banking. However, it is extremely doubtful that these are sufficient justifications for the implementation of any DPS in Hong Kong at all.
It is mentioned that in times of crisis, deposits are transferred from small banks to large banks irrespective of bank quality, and that a DPS could reduce such shifts in deposits so that well-run small banks would not suffer undue loss of deposits. This may be true, but deposits may also be returned to small banks after a crisis if those banks are well-run. On the other hand, with a DPS, deposits would stay in poorly run banks which are protected by the DPS against competition. Overall, it is more likely that a DPS lowers rather than enhances competitive efficiency in the banking system.
In addition, the fact that during crises, a "flight to quality" is manifested mainly in a "flight to bank size" reflects either a lack of information to judge or a lack of judgment on the part of depositors. If it is the former, the appropriate policy is to have banks disclose more information. If it is the latter, the introduction of a DPS merely reduces the incentives for depositors to get informed and make good judgments.
With regard to the argument that a DPS could enhance the stability of the banking system, even the Consultation Paper recognizes that a DPS does not prevent bank failures or bank runs. If protection is extended to only a certain percentage, say 75 percent, of deposits, depositors would still run on banks to minimize their losses in times of confirmed or unconfirmed bank difficulties. The same can also be said of those depositors with deposits not covered by the DPS. Even if coverage is 100 percent for everybody, some depositors would still want to withdraw their deposits promptly to avoid the inconvenience of having to wait for redemption by the deposit protection agency.
Even if it is true that bank runs might happen on a smaller scale with a DPS than without, it does not necessarily follow that the banking system is thus more stable. The ultimate solution to bank runs lies in the provision of liquidity to banks in difficulties. As such, the Liquidity Adjustment Facility (LAF) proposed recently can handle bank runs better than a DPS, and with less undesirable side effects. Under the LAF, banks that are solvent can get liquidity assistance from the Exchange Fund, while under a DPS, funds have to be channelled to failing banks irrespective of the reasons of their failure. Moreover, the existence of moral hazard on the part of banks under a DPS cannot enhance banking stability.
This leaves us with the last argument for a DPS, that is, the protection of small depositors. Presumably protection means the guaranteed payback of the par value of deposit accounts (plus any promised interests accrued). It has to be noted that deposits are one form of investment, and as such, are innately risky. It is true that risks can be reduced on the average, and traded if there is an insurance agency offering some protection policies. However, this presumes that the insurance premiums are actuarially fair, and that both the insurer and the insured participate willingly in such policies. The various schemes suggested in the Consultation Paper by no means fulfill these requirements. They impose flat-rate premiums unrelated to the underlying risks, and they require all licensed banks to join the DPS. In fact, they require all depositors at licensed banks to buy protection at a price which could amount to one-tenth of their deposit interest income, according to calculations presented in the Consultation Paper.
These differences may be the reason that the term "deposit protection" is used instead of "deposit insurance." The change in name has implications. It means the aim of a DPS is to grant protection to some deposit accounts. Since this is not so much an insurance scheme, the premiums, the participants, and other related rules can be set without much regard to insurance principles. While a private insurance agency has to have ways to protect itself against multiple or correlated failures, there is only very scanty discussion in the Consultation Paper of how the DPS can survive similar difficulties. The public's money is at stake.
Why are small depositors worthy of protection? It is perhaps morally and socially desirable to protect those depositors who are less able to protect their own deposits, either because they lack the information or sophistication, or because their portfolio is too small to diversify. But these people should not be equated with those holding small bank accounts. This is particularly true in Hong Kong now when bank deposit rates are extremely low compared to inflation rates so that few people hold large bank accounts. A small bank account could mean the holder is a poor saver and an unsophisticated investor; it could equally mean that he is a rich saver who keeps his money in various bank accounts and other investment opportunities. A DPS protects both types of depositors indiscriminately, with the costs of protection shared unfairly within the banking sector, and perhaps by society as a whole.
Previous government efforts to protect depositors were correctly focused on prudential supervision and the quality of bank management. According to the Consultation Paper, the BCCHK debacle kindled government consideration of the establishment of a DPS. The BCCHK incident was basically the result of misjudgment on the part of government officials. It was misconceived that local effort was sufficient to fend off international banking misdeeds. It would be a big mishap indeed if this is the reason for the introduction of a DPS. Under a deposit insurance scheme, banks could assume unwarranted risk since depositors are guaranteed their money by the insurer. Under a DPS, the incentive for government to exercise good judgment and sound policies would be reduced with less pressure from depositors and the public.
Dr. Luk Yim-Fai is a lecturer in the Department of Economics at The Chinese University of Hong Kong.