(Reprinted from HKCER Letters, Vol.13, March 1992)
Some Observations on the
Deposit Protection Scheme Consultation Paper
The traditional role of deposit insurance, or deposit protection schemes (DPS) as the Hong Kong government prefers to call it, has been mainly to prevent bank runs and thus to foster stability in the banking system. This role has largely been taken over by the establishment of an effective lender of last resort which lends a hand to healthy banks hit by unfounded rumors and by successive regulatory reforms which serve to prevent the deterioration of banks' balance sheets. In Hong Kong, "the government has made it clear that liquidity support for solvent banks would be forthcoming from the Exchange Fund."(Consultation Paper, p.1 fn.) The government has also, on many occasions, reaffirmed the overall health of Hong Kong's banking sector. "The main protection [to depositors] must continue to come from having a supervisory system up to international standard." (p.4)
The Consultation Paper argued that a carefully designed deposit protection scheme could perform two valuable functions:
- compensate small depositors, either fully or in part, in the event of a nonsystematic failure of any but the largest banks in a banking system; and
- enhance the stability of a banking system by raising the "crisis of confidence threshold" of the general public.
Actually, this significantly understates the value of deposit insurance.
By providing liquidity to depositors affected by troubled banks, DPS may save hundreds of well-run businesses which may otherwise be pushed into bankruptcy.
By providing the assurance that one's own liquidity and that of one's clients will not suddenly dry up because of bank closures, DPS improves the investment climate for businesses. Employment, income, and tax revenue may rise as a result. In the absence of a sound DPS, the costs of self-protection and the risks of being adversely affected by bank closures will have to be considered in running a business or in long-term investment.
By minimizing the discrimination against smaller banks by depositors on grounds of size, such banks are better able to survive. Greater competition improves the services at the larger banks and forces them to achieve greater efficiency.
By providing the same protection to the depositors of all banks rather than providing discretionary protection to individual banks, the government can avoid allegations of discrimination or unfairness.
By making it less painful for banks to wind up sick and technically bankrupt, the government can avoid being pressured into saving such banks at great cost to society.
Once we are clear about the functions that a DPS serves, we will be in a better position to work out the best design for such a scheme.
First, there is little ground for limiting coverage to $200,000 or $100,000 as proposed in the Consultation Paper. If protecting businesses is important, such limited coverage is likely to be grossly inadequate. Proponents of limited coverage either think of such limits as a way of conserving the DPS fund in the event a payout is necessary, or believe that bank deposits, as a form of investment, should be subject to risks. Accordingly, a DPS should only protect small depositors. Actually, as explained below, "fractional deposit insurance" is far more effective in conserving the DPS fund. Moreover, bank deposits, especially demand deposits, are more in the nature of money than in the nature of an investment. Particularly for deposits covered by the Hong Kong Association of Banks, Interest Rate Agreement deposit insurance is a far cry from protecting risky investments. One hundred percent exposure to risks for deposits beyond the coverage limit seems unwarranted.
Second, full deposit protection for all deposits will undoubtedly allow insured banks to engage in excessive risk taking without fear of driving away depositors. To minimize this problem, I propose that, apart from deposits in current accounts, which should be subject to full protection for liquidity reasons, deposits in savings accounts be subject to 70 to 80 percent protection. Coverage for time and foreign currency deposits should be further limited to 50 percent.
Given the importance of liquidity, prompt recovery of the protected amount by depositors is of utmost importance. In order to provide for prompt recovery of the protected deposits, a sound deposit protection scheme should have access to financing when needed. Without subsidizing the scheme, the Exchange Fund can lend to the deposit protection fund, whenever necessary, at market interest rates. If this or other sources of financing are available, there is really no imperative to build up the fund quickly. Premiums or charges should be calculated on the basis of longer-term requirements, rather than on the basis of having to build up a target amount within a defined time horizon, as recommended in the Consultation Paper.
While it is possible that bank supervisors may not act fast enough to prevent troubled banks from becoming technically bankrupt in the sense of having a net asset value of zero or below, a 70 to 80 percent protection of all deposits should provide a fairly large "margin of comfort" within which no claims on the DPF are necessary. This means that in the case of a bank closure, even though the DPS fund may face an immediate cash shortage in honoring its protection pledge, it will be able to repay any borrowed funds as long as the shortfall of bank assets below liabilities stays within that "margin of comfort." As bank supervisors are expected to take action long before a bank becomes technically bankrupt, the extra margin of comfort means that they have to be fairly incompetent in order for the DPS fund to be really burdened by the claims. Moreover, in the event that the fund faces a real cash outflow on account of such claims, coverage from the bank assets to be liquidated means that the outflows are likely to be only a fraction of the DPS-protected amounts. In light of this consideration ,and given that the Exchange Fund can lend money to the DPS fund(at commercial rates), thus obviating the need to build up a large fund quickly, the proposed charges in the Consultation Paper seem to be grossly excessive.
In estimating the needed charges to cover the cost of the DPS, the Consultation Paper imposed a 50 percent "safety factor." This immediately boosts the cost of the DPS by 50 percent. Together with the self-inflicted requirement to build up funds quickly, it makes the proposed DPS excessively costly. If our DPS fund does not want to be caught short of cash, or wants to minimize any borrowing, we can have an interim period in which the protection fraction is temporarily reduced. The protection fraction can be raised later as reserves build up. In any case, charges in excess of 0.2 percent per annum are likely to dissuade the public from supporting an otherwise worthy scheme.
To conclude, a deposit protection scheme serves important functions in a modern society. Quite apart from protecting the interests of small depositors who cannot fend for themselves, it improves the business environment for firms, making them less susceptible to bankruptcy on account of other people's mistakes. It also makes the banking industry more competitive. Depositors of large banks today may congratulate themselves for enjoying good service and security of their deposits. But the good service of the large banks may be a result of competition from smaller banks which could thrive because depositors had the impression that the government would take over any failed bank. If the BCCHK shock is to reduce such competition, the larger banks may become complacent or even arrogant with depositors. All depositors may end up suffering a decline in the quality of service, and even higher banking charges. A well-designed deposit protection scheme will protect Hong Kong from this unhappy outcome.
Dr. Ho Lok-Sang is a lecturer in the Department of Economics at The Chinese University of Hong Kong.