Deposit cover riddled with risk
Consultants Arthur Andersen are apparently about to present the Hong Kong Monetary Authority (HKMA) with a report saying bank deposit insurance is a very good idea and should be adopted.
Let us hope that the HKMA immediately drops this report in the waste bin where it belongs. Deposit insurance is not a good idea. It is a very bad one.
It is a simple enough idea and, in the form most widely adopted abroad, would entail setting up an insurance fund to which all bank depositors must contribute. If any bank covered by the scheme then goes bust, its depositors would be paid back in full from the fund to at least some size of deposit, say $100,000.
Superficially this appears laudable. Depositors could sleep soundly at night, knowing their money was safe although it is a good question how many people actually lose sleep at the moment through worrying about their bank deposits.
The big difficulty, however, is something called 'moral hazard' and although the consultants apparently concede that it is a problem they may not have recognised how big a problem it really is.
It is an easily stated problem. If you are running a small bank covered by deposit insurance and you want to make it a big bank your obvious choice is to offer higher deposit rates and lend the money out at higher interest rates to riskier borrowers.
You will get the depositors. They are protected by insurance and all they care about now is getting the highest deposit rates they can find.
For your part as the banker it is also an easy choice of strategy. If you win you win big and if you go bust from by taking on bad risks your depositors will not be hurt. Someone else will pick up the tab.
But stop there, you say. Surely there must be some way of stopping predatory bankers from taking advantage of deposit insurance schemes.
There is not. The only way is to establish a regulatory agency with such vast powers to interfere at a micro level in day to day banking decisions as to create one super-bank and allow no others.
This is justifiably regarded as something that would make banking hugely inefficient.
No country that has adopted deposit insurance has done this, not even the United States, where deposit insurance was first devised.
The result, as World Bank studies and experience across the world shows, is that deposit insurance schemes are widely correlated with bank failure.
In fact they were not even started in the US to protect depositors. They were started to protect small banks, single offices without any branches in many cases, kept that way through what was previously very restrictive banking legislation at the state level.
States that allowed safer multi-branch banking were never in favour of it, certainly not in the national form it now has and which penalises them to the benefit of small banks.
This will also be a problem in Hong Kong. Big banks do not favour deposit insurance. They provide security to their depositors through their size and are not happy to give a free ride on their balance sheets to their smaller counterparts. They are absolutely right about this too.
There is simply no getting away from the central dilemma. If you offer bait to a hungry shark that shark will take it. And you, dear reader, are not the fisherman. You are the bait.
You may think you will get greater security. What you will actually get is riskier bank lending that can easily overwhelm any insurance fund when it goes wrong and then you will get higher taxes, because governments inevitably find themselves using public funds to bail out bust banks when they create this illusion of security.
You cannot separate return on capital from risk on capital. If you want your money to be absolutely safe then keep it in banknotes and put them in the vault. Otherwise know your bank and, if that means sticking to the big ones, then do it.