Future considerations

Previously in Hong Kong, depositors have not lost their savings due principally to the government’s willingness to intervene²⁶ (i.e. implicit protection), rescue operations arranged in conjunction with certain other banks and, in the case of BCC HK Limited²⁷, recovery of depositors money has been via the liquidation process.

As the deposit base of banks grows, the cost of intervention, and consequently the burden on the government, will only increase in the future. Even in the event of a failure of a small bank, the sums involved are likely to be substantial, running into

26 For example, the government intervened in the case of Hang Lung Bank in 1983 and Overseas Trust Bank in 1985.

27 In the case of BCC HK Limited, depositors have been paid out to-date 100% of their deposits.

billions of Hong Kong dollars. Coupled with the fact that the existing explicit scheme (i.e. priority claims) does not appear to have sufficiently raised the crisis of confidence threshold to avoid bank runs, there is a strong case for enhancements to be made. A scheme developed to remove implicit protection provided by the government and designed to increase the crisis of confidence threshold would appear to be a logical step forward.

Recently, the G22 Working Party on Strengthening Financial Systems has recommended that each country put in place explicit depositor protection arrangements, with a clear specification of the nature of protection provided and the means for defraying the costs. The Working Party is also encouraging the Basle Committee on Banking Supervision to develop guidelines for deposit insurance, with particular emphasis on measures to reduce moral hazard. They also note that there are alternative forms of depositor protection schemes (apart from deposit insurance) which may be considered. These include:

Ø The priority claims procedures in Argentina and Switzerland, which ensure depositors have a priority claim on assets and that the disbursal of funds from the disposal of assets will be fast.

Ø Loss-sharing conventions in lieu of deposit insurance. This approach does not require the build up of an insurance fund, thereby reducing the up-front direct costs of the scheme and providing an incentive for potential contributors to monitor vulnerable institutions.

There is no clear consensus between market participants in Hong Kong as to whether a funded deposit insurance scheme would be appropriate. In particular, the structure of the banking sector (i.e. the disparity between a few large banks and the rest) gives rise to divergent views as to the desirability of such a scheme. These views are principally polarised, with the larger banks considering such a scheme to be a cross-subsidy to smaller banks and that it would create moral hazard issues. Smaller banks, on the other hand, consider such a scheme to be beneficial to the sector.

In contrast to the situation in Hong Kong, a funded deposit insurance scheme is an option that has been taken up by the majority of developed financial centres. For example, in the EU, all member states are required to have an insurance scheme in place and there is a clear trend towards this form of depositor protection. Therefore, the possibility of some form of deposit insurance in Hong Kong should not be ruled out.

One alternative to deposit insurance would be to enhance the existing priority payment scheme by introducing a mechanism whereby depositors would be able to get immediate pay out for part of their deposits (up to a set amount), rather than having to wait for the full process of liquidation²⁸.

This has two distinct advantages over a funded deposit insurance scheme:

28 There would have to be some form of indemnity or guarantee provided to the liquidator by the government in the event of payments wrongly made. The rights of other preferential creditors in a liquidation, including the expenses and remuneration of the liquidator as determined under the Companies Ordinance, would also have to be considered.

Ø the expected costs of setting up and running a deposit insurance scheme would be avoided, although there would be some set-up costs required²⁹; and

Ø there is no implication that large banks would be subsidising smaller banks.

The principal drawback of this scheme is that the funding required to achieve immediate pay-out would probably need to come from the government. The government would need to be prepared to take on the priority claims and, with it, the liquidation risk.

Requiring all banks to keep a certain percentage of their priority claims deposits under an asset maintenance arrangement (e.g. all banks would keep a reserve with the HKMA of Exchange Fund Bills) could provide a source of funds for such a pay-out and may mitigate the risk of loss to the government. Conceptually, the opportunity cost (e.g. in terms of flexibility or a lower interest rate) of holding this asset maintenance arrangement could be viewed as the premium that banks would have to pay.

Additionally, the immediate pay out for depositors could be limited to a proportion of their priority deposits. The remainder of their priority deposits would still be covered as priority creditors. In this way, the government and the depositors both share the burden of liquidation risk. It should be noted that this was, in effect, the actual course of action taken in the BCC HK Limited liquidation. In that case, the liquidator was requested to make an interim relief payment to all depositors (in respect of unencumbered net balances) under a guarantee from the government to cover the Joint Special Managers (i.e. the liquidators) against any payments wrongly made.

Recommendations

We consider that an enhanced form of explicit depositor protection, with the aim of improving consumer confidence and thus the general stability of the sector, would be beneficial in Hong Kong and would bring Hong Kong into line with international practices. However, before any such scheme can be implemented, it would have to first address the concerns (e.g. moral hazard and cross-subsidisation) of all participants involved. Therefore, we recommend that the HKMA (in conjunction with the government) consider the alternatives available (e.g. either deposit insurance or enhancing the priority claims scheme), by way of a more detailed study on the various forms of explicit depositor protection.

However, irrespective of whether a new or revised depositor protection scheme will be introduced, the HKMA should review whether it would be feasible to set an asset maintenance requirement for foreign branch banks. The need for this asset maintenance requirement would be to improve the effectiveness of the existing priority payment scheme as a measure of depositor protection. Such a requirement would likely be in the form of a set amount of specified assets to be held in Hong Kong, sufficient to meet priority claims under the Companies Ordinance. Therefore, the HKMA may also wish to establish a reporting system to monitor the extent to which assets held in Hong Kong cover priority claims deposits.

29 In order to provide prompt payment on liquidation, the liquidator would need the ability to download and analyse banks’

customer deposit data and would therefore need to ensure that all banks can provide this data at any time in an appropriate format.

Implications of change

As part of the detailed study into explicit depositor protection, the following issues should be considered:

To minimise moral hazard and adverse selection:

Ø consideration should be given to calculating premiums based on relative risk in order to reduce moral hazard and to avoid implicit cross-subsidies among banks;

Ø the amount of protection and who is protected should be carefully selected to avoid impairing market discipline and efficient sector resource allocation;

Ø adequate financial disclosure of meaningful information should be available to provide management, the market and regulators with the data needed to monitor and contain risk in support of depositor protection; and

Ø education to ensure the population understands the rights, obligations and protection limits associated with explicit deposit protection schemes.

To ensure the scheme is operated in an efficient manner:

Ø the source of funding for the scheme must be clearly stated and the assumption of implicit support from the government should be dispelled;

Ø there must be a system to allow for a rapid pay out of protected deposits (this may require all banks to maintain a standardised set of data that can be made available within a short period of time); and

Ø there must be adequate institution-specific and industry risk analyses to ensure that funding levels for the scheme are adequate for coverage.

1.7 Lender of last resort