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."