Deposit Protection Scheme
Dr David Nendick
Secretary for Monetary Affairs
Monetary Affairs Branch
Room 1802 F Admiralty Centre Tower 1
18 Harcourt Road
17 May 1992
DEPOSIT PROTECTION SCHEME
I am writing to set out the Hong Kong Democratic Foundation's response to the Consultation Paper issued in February 1992 on the proposed Bank Deposit Protection Scheme (DPS).
When the proposal to establish a DPS in Hong Kong was raised by various groups in the wake of the BCCI crisis last summer, the Foundation spoke out on 4 September 1991 against a simplistic approach to the perceived problems facing the banking industry. We said then that a DPS was not the answer. Now, having listened to the arguments on both sides and studied the Consultation Paper, we still feel that a DPS is not appropriate for Hong Kong and if implemented would be detrimental to the interests of the Hong Kong people as a whole. The fact that only two banks have supported it while 58 are against is a strong sign that a DPS would not be good for the banking industry. Hong Kong should look instead to a reform of banking practices and regulation, and to a new role for the Exchange Fund, to maintain confidence in the banking system.
Our submission is presented in two parts:
1. WHY A DPS IS NOT APPROPRIATE FOR HONG KONG
The objective of a DPS is generally to preserve confidence in the banking system by providing depositors with the assurance that in the event of bank failure they will recover their money. It is argued that this assurance makes runs on banks less likely as depositors protected by a DPS will have no need to rush to retrieve their money. Most DPS restrict protection to retail depositors who, it is argued, are less sophisticated and less able to diversify their deposits so as to reduce their risk.
The Foundation has the following concerns about a DPS in the Hong Kong banking environment.
1 .1 Limited coverage of the proposed scheme
The Paper suggests that funds for a DPS be built up over a five year period so as to cover the failure of one medium sized bank, i.e. one with deposits of around HK$10 billion. A larger fund could be built up, or the same target reached more quickly, if larger contributions were required from depositors. However, within any feasible funding limits it would not be possible through a DPS to protect the depositors of a large bank, or, in case of multiple bank failure, the depositors of the several banks concerned. It is also unclear what would happen under the proposed funding plan if one or more banks were to fail before the five years funding programme were complete.
The Foundation believes that the protection given by any self-financed DPS would be severely limited and that in the event of even a modest crisis in the banking system it would be inadequate to reassure depositors.
The Consultation Paper proposes that no Government funding should be forthcoming for a DPS and that it should be entirely financed by a levy on deposits. Yet virtually all the DPS in the world rely on Government support, either explicitly, or in practice when funds within the scheme prove inadequate to deal with a major disaster. The potential scale of a bank collapse is so great that no private sector institution can bear the risk of insuring against it.
The Foundation believes that if a DPS were started in Hong Kong and expectations were built up among the public that their deposits were protected, then in the event of a bank failure which the scheme's assets were inadequate to cover, the Government would face immense pressure to intervene and would almost certainly be obliged to do so. In other words, the taxpayers' money would in practice be committed to underwriting any DPSF whatever the stated terms of the scheme. The Foundation is strongly opposed to the automatic use of taxpayer's money to bail out failed banks, and believes that this would be the inevitable consequence of introducing a DPS. Indeed, most of those who argue for a DPS propose that taxpayer's money be used.
1.3 Premiums would not reflect risk
A DPS is in theory a form of insurance scheme, to which all depositors contribute and from which those depositors who lose their deposits in bank failure are returned their money. However, a major difference between bank deposit insurance and other forms of insurance is that the premiums paid by the depositors are not risk-weighted. In other words, the depositor who places his money with a risky bank pays no more than a depositor who banks with a sound one.
This deficiency is common to virtually all DPS throughout the world, although the US may now be moving towards some form of risk-weighted premium. Some implications of this deficiency are discussed below. In the context of the Hong Kong banking environment the absence of a risk-weighting is particularly invidious. In Hong Kong there are a small number of large well capitalized and prudently-managed banks in which a majority of deposits are concentrated. These banks are so large that no conceivable DPS without massive Government support could protect their depositors. Under the proposed DPS the depositors with these banks would effectively be subsidizing their fellow depositors in the smaller riskier banks. This cannot be good for the Hong Kong banking system.
1.4 Moral hazard
This brings us to the much-discussed problem of moral hazard. Moral hazard is the danger that the insured person takes more risks because under the insurance scheme he is protected from the consequences of disaster. Under a bank deposit insurance scheme the problem is particularly acute because, as discussed above, there is no risk weighting in the premium, i.e. no cost pressure on the depositor to deter him from risky behaviour. Under a DPS, insofar as it is effective, the depositor is relieved of the need to perform his assessment of a bank's creditworthiness, and is free to pursue the highest interest rates regardless of risk.
Bank management, on their side, are relieved of the need to compete for depositors' money by managing their bank prudently in a way that will inspire depositors' confidence. Under a DPS the incentive is for management to take higher risks in order to offer depositors higher returns.
The USA has one of the most generous DPS, with coverage of US$100,000 per depositor. However the USA also has one of the most troubled financial systems. The total cost of bailing out the failed savings and loan institutions is estimated at some US$300 billion. On the banking side, the Congressional Budget Office recently forecast that a further 700 US banks would fail by 1995. While deregulation and other factors are not doubt partly to blame for these disasters, most commentators regard the moral hazard implicit in the US DPS as a major contributor. It is thought that the adventures of the savings and loan institutions in junk bonds and financial engineering were motivated by management's pursuit of higher returns on behalf of depositors indifferent because of the DPS to risk.
The tendency of a DPS therefore is to encourage both depositors and banks to take higher risks. Regulatory influence may moderate this tendency. But regulators are fallible and have limited resources. The Foundation believes that there is no substitute for the concerned scrutiny of depositors to encourage sound management of Hong Kong's banks.
1.5 Contrary to Hong Kong's laissez-faire philosophy
The Foundation believes that a DPS would be contrary to the laissez-faire philosophy that has served Hong bong well for many years. Since, as we argue above, taxpayer's money would almost inevitably be used to fund the scheme, a DPS constitutes a form of welfare benefit for depositors. The Foundation supports certain kinds of welfare, and has campaigned for some time for an old age pension, for example. But while an old age pension is designed to meet the most basic and fundamental needs of our elderly, a DPS does not meet basic human needs in this way. In choosing to place a deposit with one bank rather than another, a depositor is making an investment decision, in which he balances security against expected return. The Foundation does not believe it appropriate that taxpayers' money should be used to reimburse depositors for the consequences of an adverse investment decision.
1.6 Other practical problems
The dominance of foreign currency deposits poses a problem for any DPS in Hong Kong. Only some 40% of deposits are in Hong Kong dollars. If the DSF were restricted to Hong King dollars only, this would leave 60% of deposits uncovered in the event of bank failure, suggesting that the scheme would be ineffectual. If foreign currency deposits were also covered, this would expose the scheme to exchange rate risks.
Multiple accounts would present a further problem. All DPS operate with some ceiling on the amount each depositor can claim. However, in the Hong Kong environment it would be relatively easy for individual depositors to establish accounts at more than one bank, and so gain more than their fair share of coverage.
2. RECOMMENDATIONS FOR REFORM OF THE BANKING SECTOR
The Foundation believes that in general the banking sector is not poorly regulated. However improvements in the regulatory process are nonetheless needed. The Foundation also takes the opportunity to put forward its proposals for freeing the banking market from its restrictive practices and obtaining a better deal for depositors.
2.1 Requlatory reform
At present the overseas-incorporated banks in Hong Kong are not subject at an audit, merely a review of their returns to the Commissioner of Banking. The Foundation recommends the introduction of a full-scope audit requirement for overseas-incorporated banks to put them on a par with those locally-incorporated.
The Commissioner of Banking is in the process of extending the requirements for auditors reporting to him, in that not only returns but also internal controls are to be reported on. The Foundation supports this process and would like to see the development in Hong Kong of the role of reporting auditor as operated by the Bank of England.
The Foundation is opposed to the automatic use of the Exchange Fund to provide funds to insolvent banks. However the Foundation supports the proposals currently under consideration by the Government to introduce a Discount Window (Liquidity Adjustment Facility) to relieve temporary funding shortfalls for banks that are otherwise solvent.
Given this development and extension of the role of the Exchange Fund, the Foundation believes that consideration should be given to merging the Office of the Commissioner of Banking with that of the Exchange Fund. This is the normal structure of the bank regulatory system in countries such as Britain.
2.2 Market reforms
The Foundation believes, as stated above, that there is no more powerful force for good management of banks than the informed scrutiny of depositors. However depositors in Hong Kong are not well-informed by banks accounts. The profitability of most banks in Hong Kong is still obscured by the use of inner reserves. The Foundation strongly recommends that all banks in Hong Kong are required to disclose their reserves as Hongkong Bank and Hang Seng Bank have done.
There are other deficiencies in banks' accounts. No information is provided on the quality of the loan portfolio, the extent of provisioning or other key information. Without such information, which is regularly provided in other jurisdictions such as the USA, the depositor cannot make an informed judgement about the bank to which he is to entrust his money.
Finally, the Foundation strongly urges the abolition of the interest rate cartel agreement, under which the interest rate on deposits under HK$500,000 is restricted by agreement between the member banks of the Hong Kong Association of Banks. This cartel is contrary to Hong Kong's free market principles, deprives depositors of a fair return and should be abolished.
We hope that you will give full consideration to our submission. We would also like to meet with you and other appropriate members of your department to put our concerns across more fully.
Dr Patrick Shiu
|Policy Paper - page revised 23-09-2002
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