This Chapter will consider how the respective functions and responsibilities of the Deposit Insurance Board and the HKMA should be

co-ordinated.

Structure of the safety net

8.2 Deposit insurance is only one component of the safety net for a banking system, which also includes prudential regulation and the lender of last resort (LOLR) function. In Hong Kong, the latter two functions are performed by the HKMA and the former function is proposed to be assigned to the Board.

8.3 As part of the safety net system, the roles of the regulator, the LOLR and the DIS are complementary to each other in achieving the common objective of promoting the stability of a banking system. To the extent that effective banking regulation and availability of LOLR support to banks reduce the incidence of bank failures, this would reduce potential calls on the DIS and minimise its costs. Likewise, to the extent that the existence of a DIS could prevent bank failure caused by rumour driven runs by small depositors, this would avoid the need for unnecessary regulatory intervention or provision of LOLR support. If a bank failure does occur, a DIS can reduce the resulting fall-out effects, by providing an orderly means of compensating small depositors.

8.4 The fact that each safety-net player is held accountable for its own mandate creates checks and balances in the system. But at the same time it also means that the division of responsibilities between the various agencies needs to be made clear and that their work needs to be well co-ordinated. Where appropriate, the existing arrangements should be strengthened to avoid or minimise overlapping of responsibilities or tension among the various agencies.

Means to promote smooth co-ordination between the Board and the HKMA A clear division of responsibilities

8.5 As noted by the FSF Working Group on Deposit Insurance, an important way to promote smooth co-operation between the various safety-net players is to have a clear division of powers and responsibilities. It is important for the public at large to agree, through the legislative process, what the respective roles and responsibilities should be for the DIS and the HKMA. The DIS and the HKMA each have a different role to play in achieving the common policy objective of promoting the stability of the banking system. These differences should be recognized by law. As already proposed, the functions of the Board would be confined to collection of premiums, making

compensation payments to insured depositors, and recovering the amount paid out to insured depositors upon a bank’s liquidation. Accordingly, the Board’s powers should not be more than those that are needed to fulfil those responsibilities. These functions and powers should be clearly set out in the DIS legislation (see Chapter 1) so that the Board and the HKMA could efficiently and effectively carry out their respective functions in a bank crisis.

8.6 As noted earlier, the Board may delegate some of its functions to the HKMA (e.g., premium collection and fund investment). Although it may be considered to be within the functions of the MA under the Banking Ordinance⁴⁰ to provide such assistance to the DIS, it would be helpful to include an explicit provision in the Banking Ordinance to make it clear that the MA has the function of co-operating with, and assisting, the Board to the extent permitted by the Banking Ordinance and the DIS legislation. This would put it beyond doubt that the MA may assist the Board in discharging its functions under the DIS legislation.

Review of the existing LOLR policy

8.7 There is the potential for tension between the DIS and the LOLR, e.g. in the event that a participating bank that has borrowed from the LOLR eventually fails, the LOLR could become a large secured creditor with priority over the DIS. The FSF Working Group on Deposit Insurance advised that a more rule-based LOLR policy would help minimise such problems.

8.8 In fact, the HKMA has already adopted a rule-based policy in relation to the provision of LOLR support. The pre-conditions for access to LOLR support have been codified in a policy statement issued in 1999. These include:

(i) LOLR support should be provided only when the failure of a troubled institution would damage the stability of the exchange rate, monetary or financial system;

(ii) only institutions with a sufficient margin of solvency can have access to LOLR support;

(iii) there should be no prima facie evidence that the management is not fit and proper, or that the liquidity problem is due to fraud;

(iv) the institution must be prepared to take appropriate remedial action to deal with its liquidity problems; and

40 Section 7 of the Banking Ordinance states that the principal function of the MA shall be to promote the general stability and effective working of the banking system.

(v) there are limits on the maximum amount of LOLR support that can be provided to an individual institution. For institutions with a capital adequacy ratio (“CAR”) above 6%, the limit is set at 100% of its capital base. For institutions with a CAR above its statutory minimum, the limit is set at 200% of its capital base. On top of these limits, there is also an absolute cap of HK$10 billion per institution.

8.9 Where the above pre-conditions are not met, funding support can only be granted with the specific prior approval of the FS. The HKMA therefore believes that there are already sufficient checks and balances in the existing LOLR policy which would help minimise tension between the HKMA and the Board.

Prompt corrective action

8.10 There is also the potential for tension between the DIS and the regulator, e.g. if the regulator’s action is not swift enough to prevent losses to the DIS.

8.11 This raises the question of whether a system of prompt corrective action, similar to that which exists in the US should be introduced in Hong Kong. Such a system would define a series of trigger points based on a bank’s capital strength and would mandate a set of enforcement actions for the supervisor to implement at each point.

8.12 Such a system can be helpful to limit undue supervisory forbearance. On the other hand, it can be unhelpful if it pre-commits the supervisor to a set of actions that might not be appropriate in particular cases.

8.13 In practice, the system in Hong Kong already incorporates certain features of a system of prompt corrective action. Under section 99 of the Banking Ordinance, the MA must notify the FS when he becomes aware that an authorized institution has failed to meet the minimum capital adequacy ratio set for it. The MA and the institution must then go into discussions to determine what remedial action should be taken. The MA may then require the institution to take appropriate remedial action. Failure on the part of the institution to do so is a criminal offence. Similar arrangements in relation to notification to the FS and requirement to take remedial action apply in relation to failure to keep to the minimum liquidity ratio.

8.14 The remedial action to be taken by the authorized institution concerned is not specified in the legislation in recognition that it will vary from case to case, but the broad scope of the necessary measures is quite clear, e.g. a breach of the capital ratio would require one or more of the following: injection of fresh capital, restriction of dividends, sale of assets, shrinkage of the balance sheet, etc.

8.15 The question is whether additional trigger points should be specified for the MA to take further action (e.g. to appoint a Manager under section 52 of the Banking

Ordinance) if an institution’s capital (or liquidity) position becomes increasingly impaired.

8.16 However, to a large extent, the Policy Statement on LOLR has already catered for such situation. As noted above, under the Policy Statement, where the pre-conditions for LOLR support are not met, the MA must seek the specific prior approval of the FS if further funding support from the Exchange Fund is to be provided. This would include a situation where the capital adequacy ratio of the institution has fallen below 6%. In addition, in those circumstances, the MA is committed to “consider whether to appoint a Manager under section 52 of the Banking Ordinance to safeguard the assets of the institution and to protect the interest of depositors and other creditors.”

8.17 In the HKMA’s view, therefore, there are already sufficient checks and balances built into the system to ensure that appropriate action would be taken by the regulator before a problem institution becomes critically under-capitalised. To go further down the rule-based approach would risk introducing undue rigidities into the regulatory regime.

Information co-ordination between the DIS and the HKMA

8.18 For a simple “pay-box” system, the DIS should have less need for information compared with a DIS with a broader mandate. It should have access to information about the level of insured deposits and other relevant information for the purpose of premium assessment and collection. In the case of a failed participating bank, it should also have access to specific information such as the amount and size distribution of insured deposits at the bank for the purpose of effecting timely payout to depositors.

8.19 While it is important for the Board to have the necessary powers to obtain relevant information for the discharge of its “pay-box” function effectively, it would also be useful for the Board to co-ordinate the collection of such information with the HKMA.

For example, the HKMA could collect the relevant information on behalf of the Board.

This would have the advantage of leveraging on the HKMA’s existing systems for information collection from authorized institutions and help maintain a lean management structure for the Board.

8.20 In certain circumstances, the Board should also have direct access to supervisory information provided by the MA (e.g. CAMEL ratings of institutions) for the purpose of premium assessment. It is therefore proposed that an additional gateway should be included in section 120 of the Banking Ordinance so that the MA may disclose information to the Board if such disclosure will enable or assist the Board to discharge its functions.

Petition for the winding up of a bank

8.21 After taking over the rights and interests of the depositors it has paid out, the DIS would become a creditor of a failed participating bank and would be able to file a petition for the winding up of the bank under section 179 of the Companies Ordinance. It is conceivable that the DIS might prefer to take this course of action under certain circumstances in order to protect its own interests. This could happen, for example, if the Board believes that, given its entitlement to priority claims status, the amount of money that it could recover from the liquidation of the failed bank would be larger than the amount that a potential buyer of the bank would be willing to pay to satisfy its claims.

While the grant of any winding-up petition would ultimately be subject to the leave of the Court, such action by the Board would not be desirable in cases where liquidation is not the best option to resolve the problem bank. To prevent such a dilemma, it is proposed that the DIS should co-ordinate any action in this regard with the Government, e.g., it should seek the consent of the FS before presenting any winding-up petition to the Court.

The FS should refuse consent only when he considers that it would be in the public interest to do so.

ANNEX A

Summary of HKMA’s Proposals on the Detailed Design of the DIS

Design features HKMA’s proposals

Structure and

administration of DIS

The DIS should be run by a new statutory body called the “Hong Kong Deposit Insurance Board” operating as a “pay-box” with a lean structure. The Board should consist of at least 7 but not more than 10 members appointed by CE/SAR. The number of lay members should be more than the total number of ex-officio and executive members.

The Board’s functions should be confined to collection of premiums, management of the DIS Fund, assessment of claims, making compensation payments and recovering payments from the estate of the failed participating bank. It should be given the necessary powers to discharge those functions.

The Board should be able to appoint agents, or authorize third parties, to perform any of its functions. This would help to maintain a lean structure for the DIS.

The Board should be required to maintain proper accounts which should be audited every year by an external auditor or the Director of Audit. An annual report should be prepared and laid before the Legislative Council every year. The Board’s annual budget should be approved by the Financial Secretary (“FS”).

The Board and its staff members and agents should be subject to confidentiality provisions in the DIS legislation.

As a non-profit making organisation, the Board should be exempt from taxation.

Membership Participation should be compulsory for full licensed banks (both locally and overseas incorporated). Membership should be automatically granted to an institution which has been granted a banking licence and withdrawn if its banking licence is revoked.

However, foreign incorporated banks may be exempted from participation if the deposits with the Hong Kong offices of the bank are protected by a scheme in the bank’s home jurisdiction and the scope and level of protection afforded by that scheme are not less than those afforded to such deposits by the DIS in Hong Kong.

Coverage Coverage limit should initially be set at HK$100,000 per depositor per bank. It should be reviewed and adjusted as appropriate from time to time.

Design features HKMA’s proposals

Coverage (continued) Coverage should include the principal amount of an insurable deposit and any interest accrued thereon (at the relevant contractual rates) up to the date of appointment of a provisional liquidator. However, where it is uncertain whether a provisional liquidator will be appointed or where to wait for such appointment would unduly delay compensation payment by the Board, the Board may determine that the compensation payment should cover interest accrued only up to the date on which DIS payout is triggered.

For trust accounts, the trustee(s) should be treated as a separate depositor. For bare trusts (i.e. where a trustee holds property for a beneficiary who is absolutely and solely entitled to that property), each beneficiary should be allowed to claim according to his entitlement to the account but such claim should be aggregated with the balances in his other accounts in determining the amounts insured.

For client accounts, the underlying principals (rather than the agent who holds the accounts) should be regarded as the claimants provided that the agent (i) has declared to the bank that the account is held for the benefit of its principals and that it maintains proper records of the identities and entitlements of its principals in respect of the account at all times; and (ii) makes an annual disclosure to the bank regarding the number of principals and their respective entitlements underlying such accounts. The entitlement of each principal in such accounts should then be aggregated with the balances in the other accounts of the principal in determining the amounts insured.

Joint accounts should be deemed to be equally owned by all the account-holders unless there is satisfactory evidence as to their otherwise respective shares. The deemed share of each of the account-holders should then be aggregated with their respective other claims in determining the amounts insured.

Partnership accounts should be treated as a joint beneficial claim separate from those of the individual partners.

Both HK$ and foreign currency deposits should be protected to the same extent. All payouts should be made in HK$ irrespective of the currencies in which the deposits are denominated. The applicable exchange rate should be the market rate as at the date on which DIS payout is triggered.

The Board should have the power to determine the order in which deposits in different currencies should be paid compensation subject to the principle that this would help to minimise the Board’s potential exposure to foreign exchange risk.

Design features HKMA’s proposals Exclusion from

coverage

The following should be excluded from

protection:-(i) Term deposits where the current term agreed to by the depositor at the most recent time it was negotiated exceeds 5 years;

(ii) Deposits that serve as collateral;

(iii) Deposits secured on the assets of the failed participating bank;

(iv) Bearer instruments such as certificates of deposits;

(v) Deposits booked with a foreign office of the failed participating bank;

(vi) Deposits held for the account of the Exchange Fund;

(vii) Deposits held by a multilateral development bank;

(viii) Deposits held by a holding company that holds all of the shares of the bank, a subsidiary of the bank, or a subsidiary of the holding company;

(ix) Deposits held by a director, controller, chief executive or manager of the bank, a subsidiary of the bank, a holding company that holds all of the shares of the bank or a subsidiary of the holding company; and

(x) Deposits held by an authorized institution.

Netting approach A depositor’s liabilities to the failed participating bank should be completely set off against his deposits before his entitlement is determined.

A lesser sum may be paid to a depositor as interim settlement where there is uncertainty as to the depositor’s overall net claim and/or in the interests of a speedy payout.

Assignment The rights and remedies of a depositor, including his right to priority payments, should, to the extent of the amount of the compensation payment received by him, be transferred to, and vest in, the DIS.

Trigger criteria The Board should make payment to the insured depositors of a participating bank

where-(i) a court order has been made to wind up the bank; or (ii) a Manager (as defined in the Banking Ordinance) has been

appointed to manage the affairs of the bank under section 52 of the Banking Ordinance or a provisional liquidator has been appointed in respect of the bank and the Monetary Authority (“MA”), after consultation with the FS, has notified the Board that it is appropriate that payment should be made to insured depositors by the Board because either:

(a) the MA believes that the bank is likely to become unable to meet its obligations, or that it is insolvent or about to suspend payment to depositors; or

(b) the MA believes that payment to depositors by the Board is necessary to promote the general stability and effective working of the banking system.

Design features HKMA’s proposals

Funding An ex ante fund should be built up within approximately 5 years.

The target fund size should be set at 0.3% of the total balance of insured deposits of all participating banks (approximately HK$1.5bn based on the level of insured deposits as at May 2001). The target fund range should be set at +15% and –30% of the target fund size. A rebate or surcharge will be triggered if the balance of the DIS Fund is

The target fund size should be set at 0.3% of the total balance of insured deposits of all participating banks (approximately HK$1.5bn based on the level of insured deposits as at May 2001). The target fund range should be set at +15% and –30% of the target fund size. A rebate or surcharge will be triggered if the balance of the DIS Fund is