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)

CAMEL Rating Premium duringfund build-up (bp)

Premium afterfund build-up (bp)

1 5 0.75

2 8 1.0

3 11 1.5

4 & 5 14 2.0

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