(Reprinted from HKCER Letters, Vol.59, May/June 2000)
Does Hong Kong Need Deposit Insurance?
Kam Hon Chu
Hong Kong is one of the few international financial centers without a deposit-insurance scheme. In response to recurring banking crises, the feasibility of instituting such a scheme has been considered several times as a "remedial" meausre to stabilize the city banking system.1 But the proposal to put in place deposit insurance has been repeatedly rejected, partly because of lack of support, if not strong opposition, from major banks, and partly because of the Hong Kong Government's insistence on maintaining its policy of positive non-interventionism. In light of the recent Asian currency crisis, however, the Hong Kong Government's interest in reconsidering the feasibility of setting up deposit insurance to protect small depositors has revived, and a few local banks have offered their support. That it will protect small depositors is one of the many arguments in favor of deposit insurance. The rationale is that small depositors usually do not have the expertise to individually monitor bank performance, or that it is too costly for them to do so; there is therefore a role for the government or the central bank in monetary management and banking. The goal of protecting small depositors is undoubtedly well-intentioned in terms of morality, but "good" intentions, as history amply demonstrates, do not necessarily result in sound economic policies and welfare-improving consequences; in fact they can sometimes simply serve as excuses whereby bureaucrats and interest groups can pursue their own objectives.
The recent consultancy study on the strategic outlook of the Hong Kong banking sector over the next five years (KPMG and Barents 1998) may serve as an appropriate example of misguided good intention. Among their many recommendations deregulation of the existing interest-rate caps and implementation of an enhanced explicit deposit-insurance scheme seem to have a common objective of improving the benefits of depositors. However, contrary to the way it may seem on the surface, these two changes, when implemented simultaneously, could potentially lead to instability in the banking system and could cause welfare losses to depositors or to society. With reference to Canada's experience with deposit insurance, this article argues that deposit insurance is not an effective and efficient mechanism to maintain banking stability.
Deposit Insurance in Canada
In sharp contrast to its U.S. counterpart, the Canadian Deposit Insurance Corporation (CDIC) was set up in 1967 against a backdrop of banking stability; no bank failures or runs preceded it. As a matter of fact, the last bank failure in Canada occurred in 1923 when the Home Bank of Canada was suspended.2 One explanation for this is the so-called efficiency hypothesis, according to which deposit insurance was introduced to prevent "contagious" effects following the failure of a trust company and its mortgage loan affiliate in 1965 (Cameron 1992, p. 339),3 thus ensuring a stable financial system. Carr, Mathewson, and Quigley (1995) recently challenge this traditional view with a political hypothesis, according to which deposit insurance was introduced to support relatively weak and risky financial institutions (i.e., the trust and mortgage loan companies) so that they could compete with their large and stable competitors (chartered banks). Chartered banks were unwilling to participate in the deposit insurance scheme unless regulation of provincial trust and mortgage loan companies was tightened and insurance premiums were risk-rated. The premiums were not risk-rated when the scheme was implemented, but favorable changes, such as the removal of the 6% interest ceiling on loans, the granting of full access to the mortgage loan market, and a reduction in the cash-reserve requirement, were made in the Bank Act of 1967. Such changes are interpreted as partial compensation to chartered banks for their joining the deposit insurance scheme. Saunders and Thomas (1997, p. 427) also agree that the deposit-insurance setup was more political than economic, partly because of the prevailing attitude toward increasing the role of the Federal Government of Canada in the economy.
Empirical evidence lends support to the political hypothesis, as the Canadian financial system became relatively more unstable in terms of financial-institution failures after the introduction of deposit insurance. The Canadian Commercial Bank and Northland Bank both obtained their charters in 1975 and collapsed in 1985; these events marked the first bank failures in more than sixty years. Since its setup in 1967, the CDIC has provided deposit protection to forty-three insured financial institutions -- including four chartered banks -- causing an accumulated deficit, which peaked at C$1,747 million at the end of fiscal 1995, for the program. Fortunately, subsequent recoveries of loans and claims receivable were able to eliminate the deficit and ended fiscal 1999 with a C$27 million surplus, compared with a deficit of C$539 million a year earlier. This insolvency record is consistent with the prediction that non-risk rated deposit insurance encourages the entry of weaker financial institutions because of the subsidy from incumbents and taxpayers.4 More financial institution failures are also consistent with the well-known moral hazard problem associated with deposit insurance, that is, financial institutions have incentives to take excessive risks to maximize the value of the guarantee from deposit insurance. Overall, the Canadian experience clearly shows that deposit insurance fails to promote banking stability; in fact, the banking system enjoyed a long period (1890 - 1966) of stability in the absence of deposit insurance.5 According to Carr et al., the absence of deposit insurance provided incentives for prudent bank management as well as for monitoring by depositors and regulators, and the absence of unit banking and other regulatory restrictions to competition facilitated the emergence of a relatively small number of well-managed banks through efficient mergers.
The instability of the Canadian banking system in the last decade was mainly due to the co-existence of deposit insurance and the deregulation of the financial services industry. Deposit insurance removes depositors' incentives to discriminate between prudently managed depository institutions and risky ones, allowing the rapid expansion of the latter by offering higher deposit interest rates. This also explains the U.S. banking crisis that occurred in the 1980s.6 After the Regulation Q deposit-rate ceilings were phased out, banks and savings and loan associations that wanted to pursue rapid growth and take on risky projects could attract funds by issuing larger-denomination insured certificates of deposits with much higher interest rates than those offered by their competitors. The positive relationship between high deposit interest rates and the riskiness of banks has long been recognized by bankers and economists, as Willis et al. (1933, p. 560) pointed out when they expressed a commonly held view of the U.S. banking industry in the 1920s: "there is no doubt that payment of higher interest rates [on deposits] has been the cause for the making of speculative loans and the purchase of doubtful securities which have, in turn, contributed so largely to bank failures during the past decade of this century." In the absence of deposit insurance, depositors would have been more cautious about providing high-rolling banks with funds because of the realistic expectation that they might not get the funds back. But with deposit insurance in place, depositors were more than happy to make deposits in banks with the highest deposit interest rates because the safety of their deposits was guaranteed by the government. The Federal Deposit Insurance Corporation and Regulation Q were introduced by the Banking Act of 1933. The original rationale for deposit-rate ceilings was to protect bank insolvency by stifling deposit-rate competition. It also helped contain the moral hazard problem associated with deposit insurance. This explains why deposit insurance was successful in stabilizing the U.S. banking system for decades. Unfortunately, the recent study on the Hong Kong banking industry by KPMG and Barents seems to have overlooked the lessons from both the U.S. and Canadian experiences, as it recommends the deregulation of deposit interest rates and the introduction of deposit insurance at the same time. If the Hong Kong Government adopted both recommendations, then the safety and soundness of the Hong Kong banking system would be weakened rather than enhanced. Both interest-rate ceilings and deposit insurance distort the verdict of the marketplace by protecting uncompetitive, risky financial intermediaries from competition by more prudent and efficient institutions. What Hong Kong needs to enhance the competitiveness of its banking system is the deregulation of interest rates but not deposit insurance.
Banking crises occur in all economies. While Hong Kong has experienced many banking crises throughout its history, it has also demonstrated its resilience. Deposit insurance can have a therapeutic effect in terms of ending banking crises, as it did in the United States during the Great Depression (Friedman and Schwartz 1963). But Hong Kong has no such urgent need for deposit insurance to stabilize its banking system. A flat-rate deposit-insurance scheme, once introduced, is highly irreversible and extremely costly to society, as evidenced by the experience of Canada, not to mention the savings and loan debacle in the United States. Although there are legitimate reasons to protect small depositors, there are more efficient and less costly alternatives than deposit insurance. If Hong Kong introduces deposit insurance based on political rather than economic factors, it will distort incentives and undermine the market mechanism that has contributed to its economic success. Because of its undesirable impacts, deposit insurance is more likely to jeopardize than to strengthen the status of Hong Kong as an international financial center.
Cameron, N. (1992) Money, Financial Markets and Economic Activity, second edition. Addison Wesley.
Canadian Deposit Insurance Corporation. Annual Reports, various issue.
Carr, Jack L., Frank Mathewson, and N.C. Quigley (1995) "Stability in the Absence of Deposit Insurance: the Canadian Banking System 18901966," Journal of Money, Credit and Banking 27(4): 113758.
Friedman, Milton, and Anna Schwartz (1963) A Monetary History of the United States 18671960. Princeton: Princeton University Press.
KPMG and Barents Group LLC (1998) The Hong Kong Banking Sector Consultancy Study: Hong Kong Banking into the New Millennium. A consultancy study commissioned by the Hong Kong Monetary Authority.
Saunders, A. and H. Thomas (1997) Financial Institutions Management. First Canadian Edition. Toronto: McGraw-Hill Ryerson.
Willis, H. Parker, John M. Chapman and Ralph W. Robey (1933) Comtemporary Banking. New York: Harper and Row.
1The feasibility of a deposit-insurance scheme was examined in the early 1980s following runs on Sun Hung Kai finance Company (the predecessor of International Bank of Asia) in 1978 and the now-defunct Hang Lung Bank in 1982. The idea was re-examined in the early 1990s following runs on a couple of banks triggered by the collapse of the Bankof Credit and Commerce Hong Kong Ltd in 1991.
2While there were runs on two trust companies -- British Mortgage and Trust Company and York Trust -- in 1965, the chartered banks were stable and unaffected.
3The runs can be interpreted as rational responses of depositors rather than contagious. British Mortgage and Trust was known by the public to have been lending heavily to Atlantic Acceptance Corporation, an insolvent financial institution. York Trust had substantial operating losses of 45% of its equity over the previous two years before it experienced a run (Saunders and Thomas 1997, p. 427).
4A new differential premium by-law was brought into force on March 31, 1999. Under the by-law, member institutions are classified into different risk categories based on a number of criteria, such as capital adequacy, profitability, efficiency, asset quality, and asset concentration. The CDIC levies different premium rates on member institutions based on the risk profile of each institution.
5There were only 22 bank failures between 1867 and 1923, and none whatsoever from 1923 to 1966.
6It should be stressed that there are many economic and political forces driving the banking crises in Canada and the United States. Here we examine only one aspect -- the deregulation of deposit interest rates and deposit insurance.
Kam Hon Chu is Assistant Professor of the Department of Economics, Memorial University of Newfoundland in Canada. He can be contacted by email at email@example.com
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