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 Kong’s 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

4. 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 HK$100,000 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

6. 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)

7. 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)

8. Issues arising during the consultation • Is it necessary? • Why should large banks pay for something they won’t need? • Cost • Moral hazard

9. 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

10. 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

11. 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

12. Guiding principles for system design • Don’t try to protect against systemic crisis • Keep it simple • Keep it aligned with DIS objectives • Keep it cheap

13. 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

14. Key design features: coverage • Coverage would be kept low - • up to HK$100,000 (US$12,800) • 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

15. 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

16. 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

17. 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)

18. Key design features: funding (3) • Initial target for fund size = HK$1.5 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

19. 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)

21. 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

22. 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

23. 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)

24. 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)

25. 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

26. 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

27. 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

28. 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