How Chinese banking can profit from a borrowed idea of old Canton

Andrew Sheng discerns lessons about the importance of strong supervision of risk-taking

PUBLISHED : Saturday, 19 January, 2013, 12:00am
UPDATED : Wednesday, 28 September, 2016, 8:44am

The best Christmas present I got last year was a preview of a forthcoming book by a banker-historian in Boston. He sent me his doctoral thesis, a piece of masterly detective work on how ideas travel over time and space, become adopted successfully in a different place, and then come back to where they started.

Dr Frederic Grant Jnr's forthcoming book uncovered how the US bank deposit insurance system has its root in ideas borrowed from 19th-century Canton. The origins of the US deposit insurance scheme arose from the 1829 Safety Fund Act of the state of New York, first drafted by an entrepreneur named Joshua Forman.

In those days, if the state-authorised banks failed, the state would have to pay for their failure. Forman borrowed the idea from Canton that those authorised for privileged trade (in banks, the privilege of private currency issue) should be responsible for their own debts.

The success of the New York safety fund inspired the adoption of similar schemes by other US states. The Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC) following the failure of many banks across the US. This idea of a national deposit insurance scheme has been widely adopted around the world, and is currently being considered in China.

How did Forman get the idea about the Canton system? Apparently, New York was already a major port for US-China trade and the scheme was familiar to New York businessmen.

How did the Canton system evolve? It all came about because the Qing dynasty official merchants, namely merchant houses (or hongs) authorised by Beijing to conduct foreign trade, often required trade credit to do so. If these traders defaulted on their loans, the foreigners threatened to take action on the weak government. Hence, in order to prevent individual merchant failure, the Qing government used a collective responsibility method evolved by the Manchu court that ensured those authorised to benefit from foreign trade also guaranteed each other's trade debt, and a premium was paid yearly into a fund to pay off any individual failure.

The Qing government solved the problem of default by imposing collective responsibility. The group as a whole made sure no member got into trouble, engaging in what is today called "peer surveillance".

But with this collective guarantee, the smaller traders had an incentive to take higher risks, creating moral hazard - private gain at collective loss. Moreover, as history showed, if trade was really bad, more traders failed and since the Qing government also borrowed or taxed the accumulated fund regularly, there was not enough money to settle all debts. Eventually, the fund failed.

Corruption and the misappropriation of funds were to blame, but the main culprit remained what Grant calls "the perennial dilemma of inadequate capital and lack of access to affordable credit" for the smaller hongs.

These problems plague all deposit insurance schemes, even today. Large banks are loath to support deposit insurance because they pay a larger share of the premium than smaller banks. Small banks enjoy the group insurance, but are more prone to failure because they are more likely to take more risks, which means supervision is needed to make sure they do not destroy the group as a whole.

Deposit insurance has worked very well in the US, as the FDIC not only participated in supervision of the insured banks, but also engaged actively as the mortuary of failed banks. In the current crisis, the FDIC smoothly managed the exit of over 400 banks without disruption to the system as a whole.

This time, it was the failure of the shadow banks and larger banks that created the problem. Yes, smaller banks failed, but they did not take down the whole system because deposit insurance prevented large-scale bank runs at the retail level.

The time has come for China to adopt a formal deposit insurance scheme. There are at least three good reasons why. First, deposit insurance will help stop retail bank panic, exactly the reason for the Canton fund.

Second, there must be an orderly exit mechanism for financial institution failure.

Third, based on my experience, regulators who are good at daily operations may not always be good at conducting the messy operations of restructuring failed banks. Deposit insurance is specialised work and needs specialised skills.

As Grant rightly said, the Canton scheme offers a number of valuable lessons to the modern world. They include: the tax that supports a guarantee fund must be based on measured risk of loss; the fund and its "insureds" must be made subject to strong independent supervision; laws enacted to avoid risk contingencies must be enforced; and both corruption and the diversion of fund assets must be strictly prohibited.

The trouble is that we never seem to learn from history.

Andrew Sheng is president of the Fung Global Institute