Enhancing Deposit Protection in Hong Kong

1
Enhancing Deposit Protection in Hong Kong

• David Carse
• Hong Kong Monetary Authority
• 11 July 2002

2
Objectives

• Explain the thinking behind the decision to
  introduce deposit insurance in Hong Kong
• Describe the main design features of the proposed
  scheme and the rationale for these

3
Why introduce deposit insurance?

• Hong Kongs banking system is robust and our
  supervision is generally regarded as effective
• But we cannot say that banks will never fail
• We should have contingency plans in place in case
  they do
• Avoids the need to improvise in a crisis
• Should mitigate the risk of rumour-driven runs

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Objectives of deposit insurance

• A deposit insurance scheme (DIS) should help to
  meet the following objectives -
• provide an orderly means of compensating small
  depositors if a bank fails
• reduce the probability of failure by reducing the
  risk of rumour-driven runs
• reduce fall-out effects if failure does occur
• define more clearly the role and extent of
  government support in protecting depositors

5
The current arrangements

• No DIS
• Depositors have priority of up to HK100,000 in a
  liquidation
• This has certain limitations -
• no certainty of full payment of priority claims
• uncertain timing of payment
• lack of pre-determined contingency plan
• Current arrangements lack liquidity and
  credibility

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Overview of the proposed arrangements

• Adding liquidity back-up to the current scheme
• DIS undertakes to compensate depositors (up to
  predetermined limit) if the bank fails
• DIS steps into the shoes of the depositor as a
  priority creditor
• DIS Fund is there to meet possible shortfall loss
  and funding costs (prior to repayment by
  liquidator)

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The history so far

• KPMG Strategic Review of the banking sector (Dec
  1998)
• AA Consultancy Study on Deposit Protection (July
  2000)
• 1st Public Consultation on concept (Oct 2000)
• Approval by Exco (April 2001)
• 2nd Public Consultation on details (March 2002)

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Issues arising during the consultation

• Is it necessary?
• Why should large banks pay for something they
  wont need?
• Cost
• Moral hazard

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Moral hazard (1)

• Acknowledged to be a potential risk with deposit
  insurance
• Irresponsible behaviour by banks/depositors could
  give rise to increased systemic risk
• But research findings on this are mixed
• Depends on the design of individual schemes and
  the institutional environment

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Moral hazard (2)

• Some studies (e.g Demirguc-Kunt and Detragiache)
  argue that deposit insurance increases the risk
  of banking crisis
• Others (e.g Eichengreen and Arteta) suggest that
  there is just as much evidence of a stabilising
  influence through reduction in depositor panic
• ECB study (Gropp and Vesala) finds strong
  evidence that the introduction of explicit
  deposit insurance reduces moral hazard

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Moral hazard (3)

• Despite the different views, we agree that we
  need to contain moral hazard
• Try to achieve this through -
• effective regulation and supervision
• avoidance of over-generous compensation
• differential premium
• financial disclosure that encourages market
  discipline

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Guiding principles for system design

• Dont try to protect against systemic crisis
• Keep it simple
• Keep it aligned with DIS objectives
• Keep it cheap

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Key design features membership

• Participation by banks would be mandatory
• Foreign banks in Hong Kong would be included -
• because of their significant presence in the
  retail deposit market
• Deposits in foreign branches of Hong Kong banks
  would not be covered

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Key design features coverage

• Coverage would be kept low -
• up to HK100,000 (US12,800)
• coverage of about 84 of depositors by number but
  only 16 of deposits by value
• lower cost and would also leave room for market
  discipline
• Eligible claims paid in full (no co-insurance
  because of low coverage limit)
• Foreign currency deposits would be covered
• Interbank and connected deposits excluded

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Key design features netting

• Original preference was to pay depositors as much
  as possible on a gross basis -
• only partial netting of the liabilities of the
  depositor of the bank against his claims on the
  bank
• better meets liquidity needs of depositors
• However, this conflicts with current insolvency
  rules (no appetite to change these) -
• would lead to increased losses by DIS from
  potential mismatch between amount paid out to
  depositors and amount due from liquidator
• Therefore, we now intend to adopt policy of full
  netting of liabilities against claims

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Key design features funding (1)

• Funded by the banks
• Build up a small fund in advance (ex ante)
• help bolster depositor confidence by speedy
  payout through having a ready pool of funds
• avoid raising bulk of funds after failure (ex
  post) when banking sector is already weak
• banks that fail have contributed to the fund
• favoured by banks as they can plan and budget for
  annual contribution costs

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Key design features funding (2)

• Distinguish between capital and liquidity needs
  of the DIS
• Capital adequate to cover potential losses caused
  by-
• recovery shortfall i.e. inability to recover
  amounts paid from the estate of the failed bank
• finance costs for the period until funds
  recovered from the estate
• Liquidity required to fund payout to depositors
  would be provided by a separate back-up facility
  (from Exchange Fund)

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Key design features funding (3)

• Initial target for fund size HK1.5 billion
  (0.3 of deposits)
• Based on Monte Carlo simulation (10,000
  iterations)
• 99.8 confidence interval (BBB-rating)
• Sufficient to meet failure of 2 medium size banks
• Built up over 5 years
• Provision for rebates and surcharges to keep fund
  within target range

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Key design features premium (1)

• Initial premium would be set initially at a level
  sufficient to build up the capital of the fund in
  5 years -
• central rate of 8 basis points would be paid by
  most banks
• differential premiums based on CAMEL rating
• Reduce the premium (central rate of 1 basis
  point) to cover only expected annual loss once
  fund reaches target level

20
Key design features premium (2)
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Key design features status of the DIS (1)

• DIS would be established as a statutory Board
  with majority of lay members
• It would operate only as a paybox, not as a
  separate regulator -
• small size of Hong Kong market does not support a
  separate body that also regulates the banks
• comparative rarity of bank failures does not sit
  well with having a large risk minimising machinery

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Key design features status of the DIS (2)

• Functions of the Board would be to
• collect premiums
• manage the fund
• make payouts to depositors
• claim in a liquidation as a priority creditor
• The functions and power would be captured in
  legislation
• HKMA would be continue to be the sole regulator
  of the banking sector

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Key design features trigger criteria

• Payout by DIS would be triggered if -
• winding up order made, OR
• a Manager under the Banking Ordinance or
  provisional liquidator appointed, AND
• MA notifies the Board that payout should be
  triggered because bank is likely to become unable
  to meet its obligations or is insolvent
• Thus, Board cannot unilaterally trigger payout
  (consistent with paybox role)

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Key design features Board and HKMA (1)

• Proposed structure of the safety net -
• HKMA bank regulator and Lender of Last Resort
  (LOLR)
• Board deposit insurer
• As already noted, need for clear division of
  responsibilities to be enshrined in law (e.g. as
  regards who triggers payout)
• In practice, the Board may delegate some of its
  administrative responsibilities to HKMA (e.g. for
  premium collection)

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Key design features Board and HKMA (2)

• Scope for tensions between HKMA and Board -
• over-provision of LOLR support to keep a failing
  bank afloat
• regulatory forbearance
• However, these risks should be mitigated by -
• existence of explicit LOLR policy statement
• prompt corrective action features of the BO
• sharing of supervisory information with Board

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Key design features Board and HKMA (3)

• DIS Board will need to obtain information from or
  through HKMA in order to -
• assess annual premium due from individual banks
  (amount of insured deposits and CAMEL rating)
• review the risk profile of its portfolio of
  insured banks to update target fund size and
  annual premium
• prepare for possible failure of a problem bank
• make the payout if the bank fails

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Key design features Board and HKMA (4)

• DIS legislation must therefore provide a gateway
  for HKMA to disclose the relevant information to
  the DIS
• Arrangements need to spelt out in a MoU between
  HKMA and DIS Board
• Board and DIS employees need to be subject to
  confidentiality requirements

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The way forward

• The HKMA is finalising the detailed design
  features of the DIS
• Legislation will be required
• Bill on DIS ready by end of 2002
• Implementation by end 2003 or 2004 depending on
  progress in Legco