(Reprinted from HKCER Letters, Vol. 10, September 1991)
Deposit Insurance in Hong Kong?
The debacle of the Bank of Credit and Commerce Hong Kong Ltd (BCCHK) last July and the subsequent bank runs sparked off much public attention and a series of exchanges on the desirability and ways to reform the local banking system. One fashionable proposal is the introduction of a deposit insurance scheme. Such a proposal is by no means novel. There have been repeated calls by academics for deposit insurance in the early and mid-1980s, typically amid times of banking crisis; but the government has been firm in its denial of the need for such a scheme. This time, however, government officials have softened their position and promised the public a consultative paper on the subject by the end of the year. Whether this represents a concession to depositors and the Consumer Council or a ploy to cool down public sentiment after the BCCHK incident remains to be seen. A deposit insurance scheme has the dual functions of assuring the small and relatively unsophisticated depositors a safe form of investment and stabilizing the banking system against runs. In fact, the scheme can be so effective in deterring bank runs that depositors have no incentive tomonitor bank performances, especially under deposit interest ceilings such as the Interest Rate Agreement currently in effect in Hong Kong. It makes no difference where the deposits are; they are equally redeemable and they pay the same regulated interests. The greater the coverage of the insurance scheme, the more prominent this situation will be. This outcome has been misinterpreted as "fair" competition among banks under a deposit insurance scheme, while in fact, it should more appropriately be characterized as protection of incompetent banks. Nevertheless, the stabilizing features of a deposit insurance scheme are especially welcomed by the public who have just been repeatedly plagued by banking crises, irrespective of the nature of those crises. Yet deposit insurance schemes are not without their costs (not just the insurance premium) and shortcomings. The adoption of deposit insurance requires careful balancing of the pros and cons for the economy as a whole. Unfortunately, the benefits can clearly be seen by the public as depositors to whom one less dollar lost to failed banks is one dollar gained under the scheme, while the costs, though possibly greater, are much more remote because they fall on the economy as a whole. The most often quoted argument against deposit insurance is the consequent moral hazard problem associated with banks. This simply means that banks would take on riskier investment projects with the insurance than without. There is such behavior on the part of banks because should the investments fail, all the bank loses, at the most, is the equity. There is the insurer to take care of the depositors. This amounts to limited liability for the bank owners. If the latter care only about expected returns, they will undertake risky projects that may either yield very high returns or fail disastrously. Even if they dislike risk, they would still take on more risk with deposit insurance. Furthermore, bank investment decisions are generally not made by shareholders collectively. There may not be sufficient incentives for the few decision makers to act in the true interests of the numerous shareholders. Bank managers would reap lucrative bonuses when risky projects prove successful, but it is the value of the equity that suffers when the reverse takes place. Alternatively, with a deposit insurance scheme, bank owners can be seen as holding a put option in addition to the assets and liabilities on the bank balance sheet. The striking price of the option amounts to the value of the bank's deposit liabilities. When the value of assets exceeds that of liabilities, or when the net worth is positive, they simply choose not to exercise the option. When it is the opposite, they would choose to exercise their right and sell the depreciated bank assets for the pre-determined striking price, with which they pay the depositors. In return for this option, banks have to pay the price of the option, which in effect is the deposit insurance premium. The moral hazard problem is far from just a theoretical possibility. Recent empirical evidence from banking in Texas, a region with numerous bank failures in the 1980s, has shown a positive relationship between deposit insurance and bank risk taking. Even if the moral hazard problem is assumed away, the establishment of a deposit insurance scheme begs quite a few questions. The basic nature of insurance is the sharing and pooling of risks. The insurer protects the insured in return for the premium it receives. Yet the insurer needs some means to protect itself as well in order for the insurance scheme to be feasible and sustainable. Usually this is done by acquiring information about the insured and pricing the insurance premium to reflect the underlying risks. An insurer of bank deposits needs to have information on bank portfolios, especially the riskiness of the assets and net worth. Ideally these should be market values rather than historical book values so that resolutions would not be delayed if a bank is in poor financial health. It is doubtful that banks would be willing to reveal their true balance sheets to the insurer if the latter is a private agency, unless deposit insurance is made mandatory. Given that banks in Hong Kong have the practice of covering up the value of their inner reserves, there is a long way to go before they would reveal sufficient information on the market values and other details of their assets to private agencies. On the other hand, if deposit insurance is mandatory, it is difficult to justify that banks have to buy insurance from and make known their financial statistics to any private, as opposed to government or quasi-government, agency. Deposit insurance, to the extent that it has to be introduced, has to be government-sponsored. The pricing of deposit insurance premiums is a central problem of such a scheme, whether the insurer is a private or a governmental agency. A flat rate premium as practised in the U.S. does not link the premium to the corresponding risk and is actuarially unfair. Banks with a larger deposit base are not necessarily more prone to failure. The system would in fact encourage banks to engage in more risky adventures since doing so would not increase their insurance premium even though the probability of bank failure is enhanced. Somehow a measure of bank risk as a basis for pricing the premium is needed. Unfortunately, this can only be done imperfectly. The internationally accepted Basel Agreement came up with only five risk categories of bank assets in the calculation of the capital adequacy ratio. With such broadly defined categories, most loans are lumped together regardless of the creditworthiness of the borrowers. With the existence of asymmetric information, risk-based premiums, even if perfectly designed, may cease to be an effective tool to handle risks. Under such circumstances, an insurer has to seek or impose supplementary rules on the behavior of the insured, such as required or minimum net worth levels. The latter can be interpreted as playing the role of deductibles in other kinds of insurance. The higher the required net worth, the greater the loss to bank owners if their risk taking fails to pay off. Minimum capital requirements thus can deter unwarranted risk taking and absorb unexpected bad loans. As such, the decision of the Hong Kong government to follow the Basel Agreement in imposing a minimum capital adequacy ratio on licensed banks can in itself be a good safeguard against bank misbehavior and bank panics. The introduction of a deposit insurance scheme on top of that in fact weakens such protection with its accompanying moral hazard problem. Given that supplementary rules are necessary for a viable deposit insurance scheme, a government insurer has an advantage over private insurers in that it has the sovereign power to enforce these rules. On the other hand, government deposit insurers will be like other government officials: There is no guarantee that their decisions are made in the true interests of the taxpayers. It is certainly possible that government insurers would delay the closing down of insolvent banks in the hope that they would make a turn for the better, since the announcement of bank failures could represent admission of inadequate supervision and thus be an embarrassment to the government, or at least to the regulators. Postponement of resolution could tremendously worsen the situation since the less equity there remains, the greater incentive there is to assume undue risk under a deposit insurance scheme. Thus, regardless of the moral hazard problem, practical considerations cast serious doubts on the desirability of a deposit insurance scheme. On one hand, a private deposit insurance scheme is not viable. On the other hand, there is the danger that if the scheme is government-sponsored, it is not allowed to function purely as an insurance scheme, as in the U.S. case. The FDIC scheme in the U.S. supposedly does not cover deposit accounts over US$100,000 of value. Yet it chose to extend protection to these accounts as well when the Bank of New England failed earlier this year. Government agencies are always burdened with more considerations than private agencies, and as such are destined not to let the insurance scheme play according to purely insurance rules. The result would be that other parties, usually the taxpayers, are forced to share the risks and possibly the subsequent costs of the banking system. Perhaps the Interest Rate Agreement and the relative stability of the local banking system have both given depositors the impression that all banks are indiscriminately safe as depository institutions. The fact, however, is that deposits are one form of investment and are thus liable to risk. The latest banking crisis in Hong Kong was not due to any loophole in the local regulatory framework, and there is no case for tinkering with existing banking practices. The misfortune of thousands of depositors in last July and August were exemplified, though not caused, by conflicting government decisions. It is ironic to hear a public voice asking to consign the government with an additional mechanism to intervene in the banking system which has been messed up by poor government decisions.
Dr. Luk Yim-Fai is a lecturer in the Department of Economics at The Chinese University of Hong Kong.
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