Time to review our bank deposit insurance

The collapse of Silicon Valley Bank and Signature Bank was big news over the weekend. There was the worry that the SVB failure could trigger a major crisis if many tech companies were hit, given that the US’ Federal Deposit Insurance Corp offers protection for only $250,000 per depositor per insured bank for each account ownership category. But the Biden administration announced on Sunday that customers of Silicon Valley Bank will have full access to their deposits.

Hong Kong has not had a banking crisis for a long time. The last bank failure was the Bank of Credit and Commerce International in 1991. Moreover, it turns out that the Hong Kong branch of BCCI (BCCHK) was not really underwater. Although BCCHK was liquidated, in the end, depositors of BCCHK were able to recover “almost 100 percent of their money in liquidation”, according to the website of the Hong Kong Deposit Protection Board.

Although depositors on paper did not incur much loss in the end, at the time there was no deposit insurance, and the years of trepidation and anxiety must be most taxing on depositors. A problem with all the deposit insurance systems that we know of is that the protection is subject to a limit, which currently stands at HK$500,000 ($63,740). If depositors hold more than this amount and need full protection, they will have to split their deposits across different banks. Hong Kong is an international commercial center and a global financial center. If our businesses grow into a decent size, they will need protection for millions and perhaps tens or hundreds of millions of dollars.

I had advocated that the bank deposit system should offer “fractional deposit insurance” on top of protecting 100 percent up to a limit. A bank-deposit insurance program offering only HK$500,000 in protection is certainly inadequate for many businesses. Our bank deposit insurance should, in addition to a fixed limit for protection, offer additional protection, say 80 percent of the deposits beyond HK$500,000 and, say, 60 percent protection for deposits beyond HK$100 million.

The proposed extension of the existing deposit insurance program will produce several benefits. The first is that depositors that need protection for much more than just HK$500,000 are protected to a significant degree, and businesses will not need to worry about suddenly being caught in the situation of not being able to pay salaries and bills. That could trigger other defaults and thus lead to systematic risks. The second is that businesses will not feel compelled to split their deposits across many banks, thus saving transaction costs and accounting costs. Third, fractional deposit protection will keep depositors on alert. Banks will need to manage their finances well and show this competence in public in order to inspire confidence among depositors so they can attract deposits.

The present program is funded by contributions paid by program members based on the amount of protected deposits held with each member. Enhancing the coverage as proposed would need extra financing. But this would be worth it because it would strengthen Hong Kong’s ability to withstand crises. In financial regulations, there is the problem of “too big to fail”, and this arises because regulators are wary that a big financial institution’s collapse might lead to a domino effect of collapses, as its counterparts lose access to liquidity and cannot honor their commitments. With the proposed additional fractional deposit insurance, these counterparties will continue to have access to most of the deposits even in the event of a bank failure.

Protection of all deposits through a fractional insurance framework will reduce the need for the government to bail out a bank that has grown too big yet is poorly managed. In 1998, Long-Term Capital Management LP, a hedge fund led by a team of high-flying economists, including Myron Scholes and Robert C Merton, failed. The US Federal Reserve Board feared the possible consequences if the fund was allowed to liquidate. So it brokered a deal to bail it out. In 2008, when Lehman Brothers was about to collapse in the wake of the subprime mortgage crisis in the United States, the market thought it would be bailed out for exactly the same reason. Yet the Fed did not step in this time, and this triggered the global financial tsunami. Shortly after this, the government decided to bail out American International Group because the failure of a systemically important financial institution would likely to be too hard to swallow. Extending deposit insurance to protect all deposits fractionally goes a long way to resolving the too-big-to-fail dilemma.

Finally, I would like to propose that the threshold for full protection should be subject to inflation indexing. This means that if protection is for HK$500,000 this year, then next year, the protection should be HK$500,000 plus the amount that would offset the loss of purchasing power due to inflation in a year’s time. The availability of full protection is especially important for those whose assets are all that is held in the form of bank deposits. Indexing the threshold is easy to do with today’s technology. Together with the proposed fractional deposit insurance beyond the threshold, we will claim this to be a financial innovation pioneered in Hong Kong.

The author is the director of the Pan Sutong Shanghai-Hong Kong Economic Policy Research Institute, Lingnan University.

The views do not necessarily reflect those of China Daily.