Deposit insurance: Moral hazard here to stay

Deposit insurance: Moral hazard here to stay

HONG KONG (Dow Jones): The absence deposit insurance spelled
financial disaster for Indonesia in October 1997, reinvigorating
a debate about how much governments should be willing to
guarantee banks.

Because of experiences like that, it is now recognized that
deposit insurance is coming to Asia, despite the belief that such
guarantees can actually promote risky behavior -- a phenomenon
known as "moral hazard."

Illustrating the evolution of the debate, new studies from the
Bank for International Settlements and Merrill Lynch & Co. bypass
the moral hazard issue to highlight other dangers associated with
the deposit-protection process.

Merrill, for example, expresses concern about the design of
the deposit-insurance schemes and argues that government backing
of banking systems will likely continue.

For example, an insurance arrangement probably wouldn't be
practical for a widespread problem such as Asia experienced in
the crisis, when non-performing loans topping 30 percent in
almost every bank in some countries.

If the government were to rely only on the insurance, the
public could cause an even bigger bank run.

Coincidentally, the reports have been published amid a fresh
round of jitters about the stability of some Asian banks. In
recent days, small-sized institutions in Taiwan, China and the
Philippines have faced heavy withdrawals of deposits, prompting
depositors at other institutions to reassess their own bank's
safety.

Depositor protection aims to avoid what happened in Indonesia
two-and-a-half years ago. In that episode, the International
Monetary Fund directed the snap closure of 16 of the nation's
worst banks, just as a surgeon would remove a tumorous organ to
save a life.

The problem was that the cancer in Indonesia's financial
system was malignant disease, and pretty much everyone knew it.
So the closure of a few bad banks, in the absence of protection
for depositors at others, sparked bank runs nationwide, and
ultimately made a bad situation even worse.

Blanket deposit-guarantees are now accepted by the IMF as a
cornerstone way to close rotten banks without inducing panic.
"Once a banking crisis has become systemic, such a guarantee
often becomes an integral part of the resolution strategy,
notwithstanding its cost," a staff report published by the
Washington institution said in March.

In a more recent report, U.S. investment house Merrill Lynch
noted that many Asian governments are now moving toward formal
deposit insurance.

It welcomes the development of codified guarantees, but also
notes in its April 25 report that the process will result in a
trimming back of the implicit government backing of banks that it
says exists.

Governments will formally "cap support for the banking system
through the introduction of deposit insurance schemes," it said
in the report.

And the report warned that investors in bonds and other
instruments should carefully watch the evolution of guarantee
mechanisms.

"While we believe Asian governments will (remain) generally
supportive of their major banks, we expect evolving regulatory
behavior to remain a risk element," according to the report.

As conditions change, bank creditors, including depositors,
are expected to migrate toward stronger institutions and away
from weaker ones. And the new type of guarantees will usher in
differing levels of government support that reflects both the
type of institution and financial instrument in question, Merrill
says.

Meanwhile, Bank for International Settlements staffers have
looked at the guarantee issue from the perspective of banks
deposits with each other, or the interbank market.

The Basel-based group's 68-page report, published in March,
details how governments stand behind banks that take deposits in
the international interbank market, how rating agencies attempt
to put a value on the guarantees and the market requires them to
function.

Governments provide cost-free, tacit protection through
central banks, treasuries and international organization such as
the IMF with the aim of making the international interbank
markets viable.

The BIS study doesn't necessarily find fault with these goals
or the moral-hazard issues raised by the process. "Rather than
continue to simply lament the problem of moral hazard which
exists in the international interbank market, we propose that the
debate be shifted to how best to manage the implicit
international deposit guarantees," said the study.

But it notes the practice does raise risks in the market,
since there is a relative lack of transparency in interbank
dealings.

This is due to the fact that banks operate with a knowledge of
the guarantee, and tend to lose some of their predisposition to
carefully scrutinize the health of a counterparty when placing
deposits.

The BIS study found Asian banks generally had far higher
levels of government guarantees during the 1990s, as compared
with institutions in Latin America.

What the report criticizes about the guarantees is that they
appear to be free, although it acknowledges that making banks
absorb some of the costs or making them subject more to
government regulation is a more difficult matter.

It suggests that in exchange for support, investment
restrictions set down by regulators on the "guaranteed"
institutions could be formulated.

Alternatively, lenders could agree to take "haircuts" if their
credits ultimately go bad, although banks have stood united
against such proposals on bond contracts.

The BIS study said that without some way to induce greater
discrimination and monitoring in the markets via market
discipline and risk balancing, "the interbank market will
continue to be a large contributor to short-term international
capital flow volatility."