'Too big to fail'

KATHMANDU, MAY 02 -

When Continental Illinois, then one of the top 10 banks in the US, came under heavy pressure due to its exposure to the faltering energy sector in the summer of 1984, 24 other banks in the US came up with a rescue package, besides other measures from Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve, to prevent Continental from going under. It’s hard to imagine Microsoft and other tech firms coming to the rescue of Google if it was about to go under. While competitors love to see their rivals go bankrupt in other businesses, banking, because of the complex web of relationship between participants in the financial system, is a different ball game where a problem in a single financial institution can bring down the whole banking system.

Banking, in other words, is a sector where a bank’s long-run survivability may not only depend on its own credit and investment portfolio but also that of other banks in the financial system. As bank runs on a few problematic banks can spread to other healthier ones due to lack of trust among the general public in the banking system and damage the whole financial system, it led to the conception of deposit insurance. Deposit insurance works by providing that “trust” as it guarantees the deposits, albeit to a limit, of deposit holders.


Why deposit insurance
Banks operate to a large extent by taking short-term demand deposits and channelling a majority of those deposits into loans of a longer duration. Banks only keep a small portion of the deposits in the form of cash reserves and liquid assets, and hence, at a given time, have the ability to meet withdrawals of only a fraction of their total deposits. However, the banking system is built upon the premise that only a fraction of the total deposits is withdrawn on a given day; and as long as banks are able to offset deposit withdrawals by either rolling over existing deposits and/or taking new deposits, banks will do fine.

The premise works well during normal times when the economy is doing well and when individual banks have a good credit and investment portfolio. During such a period, given the good financial position of banks, the general public’s faith in their ability to meet their demand for deposits is high. However, we all know that the economy moves in cycles; and in an economic downturn, the credit portfolio of banks can deteriorate quickly undermining their health and long-term sustainability. As is evident from the recent financial crisis, such deterioration in credit quality can lead to bank runs as depositors, fearing closure of their banks, rush to get their hard earned savings back. Even in good economic times, some banks, because of their strategy, can have a subpar credit and investment portfolio. As the quality of their asset worsens, the public’s trust in their ability to meet their demand for deposits also starts to waver. Hence, depositors rush to these banks to get their deposits out, but these troubled banks aren’t able to fulfil all the withdrawal requests. The inability of banks to pay out to their depositors creates further panic, and more depositors rush to withdraw their deposits, which ultimately leads to closure of these banks. If such episodes of deposit withdrawal were only to be limited to troubled banks, then it would have been fine as, economically, bad banks should pay the price.

However, as history has shown, such episodes are not only confined to troubled banks but also usually spread to healthier banks as the public’s trust in the whole banking system comes under pressure. When one or a few banks get into problems, the public perceives that other banks, irrespective of their financial status, will also follow suit, and hence jump to get their deposits out, which creates a vicious cycle and can undermine the whole banking system.

While the scope of deposit insurance to limit damage in the event of a systemic problem, such as a economic downturn, which affects the asset quality of the whole banking system is debatable, deposit insurance can, to some extent, help overcome the idea that one or a few bad banks can have a severe impact on the whole banking system. By assuring the public’s deposits, deposit insurance can limit potential problems in a troubled bank and prevent the problem in one bank from spreading to other banks.


The other side to deposit Insurance
Having said that, deposit insurance, however, does create perverse incentives for both depositors as well as banks. Without deposit insurance, depositors are expected to carry out due diligence before putting their savings in a bank. Depositors punish financially weak and risky banks by asking for a risk premium in the form of a higher interest rate. The riskier the bank, the higher will be the risk premium, so banks are compelled to be financially sound and stable. With deposit insurance, however, depositors will no longer have to monitor the performance and activities of their bank as they will be compensated in case it fails. As banks face less scrutiny from depositors, they are free to indulge in risk taking activities, the so-called moral hazard problem in economics. Banks are more than happy to pay a nominal premium for deposit insurance as they no longer have to pay a higher risk premium for taking high risks.

Moreover, if deposit insurance is to be voluntary, then it can lead to another problem of adverse selection whereby only riskier banks join the deposit insurance scheme and less risky ones opt to stay out, undermining the long-run sustainability of organisations running deposit insurance.


Deposit insurance in Nepal
In the middle of 2010, Deposit and Credit Guarantee Corporation (DCGC) introduced the Deposit Guarantee bylaw paving the way for the inception of deposit insurance in Nepal. DCGC charges 0.2 percent of the insured deposits as a premium for deposit insurance, and the premium can increase by 0.1 percent if banks fail to meet the risk metrics prescribed by it. Initially, the Deposit Guarantee bylaw made deposit insurance voluntary for banks and financial institutions. However, with Nepal Rastra Bank (NRB) making it mandatory for class B and C financial institutions, and hopefully soon for class A financial institutions, it can help overcome the problem of adverse selection that is inherent in voluntary insurance schemes.

Having said that, the problem of moral hazard will persist and the onus is on NRB and DCGC to ensure that, with deposit insurance, banks don’t indulge in riskier activities as depositors, with their deposits insured, no longer have the incentive to monitor their performance. Moreover, in the future, DCGC or the government should not set the precedent of guaranteeing uninsured deposits in the event of a problem in big financial institutions. If that were to be the case in the future, it will induce banks and financial institutions to become bigger in size—a notion called “too big to fail”—whereby the government will come to their rescue every time there is a problem.

(The writer is associated with a private bank. The views expressed are personal.)




Posted on: 2011-05-02 09:07

SANTOSH POKHREL, http://www.ekantipur.com/2011/05/02/business/too-big-to-fail/333390.html