1. The Consumer Council is pleased to submit its response to the Hong Kong Monetary Authority (HKMA) regarding the current public consultation on enhancing depositor protection in Hong Kong. The HKMA's current consultation paper, based on a separate consultancy commissioned by the HKMA, raises a number of options with regard to how depositor protection can be further improved, which in turn raise particular issues. This paper examines those options and the major issues involved.
Form of Deposit Protection Scheme
Enhancing the current arrangements versus a deposit insurance scheme
2. In considering what form of deposit protection scheme should be adopted for Hong Kong, the Council's objective is that Hong Kong depositors should have a protection scheme that will advance the limited protection currently available, and bring Hong Kong into line with world's best practice. In the consultation paper, various options of enhancing the current arrangements are put forward, such as improving the existing priority payment scheme, introducing a claims advance scheme, and setting up a deposit insurance scheme.
3. The Council considers that the option of merely enhancing the existing priority payment scheme, for example, by improving the level of cover provided to depositors and increasing the clarity of the current arrangements, would mean that depositors could still be exposed to shortfall risk and loss of liquidity. Such a scheme would therefore not be able to meet in full the primary objectives of a deposit protection scheme, i.e. to provide a measure of protection to small depositors and to contribute to the stability of the financial system.
4. The option of a claims advance scheme provides that government funding would be used to advance payments to depositors against their priority claims in a liquidation. A claims advance scheme would be an improvement on the current arrangements as regards the degree of depositor protection and confidence. However, this would involve some costs to the Government. The risk to Government, in a claims advance scheme, could be reduced by requiring banks to maintain sufficient assets for meeting their obligations. However, the Council shares the view that if the banks are to contribute to a deposit protection scheme, it would be more transparent and simpler for this to be done via an explicit insurance premium.
5. Having regard to the perceived shortcomings in revising the current arrangements, the Council concludes that some form of deposit insurance scheme (DIS) is the best option for Hong Kong. In summary, the Council considers that a deposit insurance scheme would best serve the interests of consumers because:
- a deposit insurance scheme would contribute to a stable banking system, as a reasonable assumption can be made that such a scheme would provide an element of confidence in the industry and that depositors, particularly smaller ones, may be less inclined to act on rumors in the market, thereby reducing the possibility of runs on the banking system;
- in the event of a bank failure, a deposit insurance scheme would ensure that small depositors are guaranteed of receiving funds (in that they would not have to worry about a failed bank having sufficient assets to meet their claims);<
- even if a failed bank was eventually found to have sufficient assets, the payments would be much more promptly made under an insurance scheme, rather than would be the case under a priority payment scheme, because they would not have to wait for the full process of administration of assets, and recognition of creditor priority, to run its course; and
- there is a strong argument that having a deposit insurance scheme is consistent with the protection that is already in place for investors in the stock and futures markets, and the proposed improvements to that protection through amendments to the Securities and Futures Bill. It could be argued that it is equally, if not more important, that depositors' funds should have similar insurance protection, given that they could represent the life savings, and a major source of liquidity for many consumers.
6. A number of arguments have been made against introducing such a scheme. For example, that insurance-based systems promote moral hazard and lead to "commoditization" of covered deposits because depositors have less reason to discriminate between banks on grounds of risk. It is also noted that prudent banks might claim they are subsidising riskier banks in the sense that the prudent banks are helping to pay for a system which they themselves do not need and are unlikely to use. Also, there are concerns that the costs of the insurance scheme will be directly passed on to consumers.
7. The Council considers that the answer to the issue of moral hazard is strong regulatory supervision. The Council notes the good work of the HKMA and that it is already in the process of enhancing its supervisory regime to make it more risk-based. With regard to the arguments of cross-subsidisation, an element of subsidy is inherent in any form of insurance, particularly mandatory insurance. It is considered that deposit insurance would help promote competition in the market for banking services, and that as a result, strong competition between banks will play its part in reducing the extent of costs being passed on to consumers.
8. Having regard to the Council's support of a deposit insurance scheme (DIS) this paper now addresses particular issues raised in the HKMA's paper that are critical to the operation of an effective deposit insurance scheme.
Structure
Publicly Administrated and Privately Funded
9. The Council considers that a DIS should be publicly administered. The reason being that the public may perceive deposit insurance without government participation as a less credible form of insurance. Another justification is related to a point previously made by the Council regarding the difficulties arising from assessing and indicating the level of risk premiums. There is a concern that the collection of such sensitive information in private sector hands, substantiated or otherwise, may put the integrity of the banking sector at stake.
10. In view of the relatively small size of the Hong Kong market and the comparative rarity of bank failures, the Council agrees with the notion that the public DIS should confine its role largely to that of a "paybox", and suggests that its size should be kept at a minimal level in order to save costs.
11. As regards the management of funds held by the DIS, the Council suggests that a separate legal entity should be created to administer the DIS. It is noted that international best practice also seems to be in favour of a degree of separation in terms of governance between the DIS and the supervisory authority. Such an arrangement would therefore avoid potential conflicts of interest, and allow for direct consumer representation, in addition to banking and government interests, on the board.
Indicative Level of Premium
12. The modeling in the consultation paper suggests that around 10 basis points per annum would be a suitable basis for planning a DIS, and that with the proposed coverage cap of HK$100,000 this would have an adverse impact on net interest margin of less than 2 basis points for most of the retail banks in Hong Kong. The Council notes the estimation that even with a coverage cap of HK$200,000, the impact would be less than 3 basis points in most cases.
13. The consultation paper has suggested that the annual premium could be reduced or even temporarily suspended (possibly after 3 years) once an appropriate target level of reserves had been built up.
14. The Council accepts that the premium level could start with 10 basis points per annum but an annual review should be conducted so as to check whether it remains appropriate, and whether premiums need to be reduced or suspended. This is important to ensure the DIS has sufficient resources to meet expected losses; and that the premium is not excessive in that it results in a financial burden on banks which, notwithstanding the degree of competition between banks, might ultimately be passed on to depositors.
Funding Approach
'Ex ante' versus 'Ex post'
15. The Council notes that the ex ante funding approach, which entails the creation of up-front funds or cash reserves against contingent liabilities, is applied by the majority of DIS around the world. Also, as indicated in the consultation paper, the majority of banks surveyed favoured ex ante funding.
16. The Council is disposed to favour an ex ante approach. However, it notes that in view of the complexity of the various approaches to funding described, the HKMA has stated that further technical and analytical work should be done on these aspects if a decision is taken to introduce a DIS. The Council supports this approach.
Main Design Features of DIS
17. With regard to the various options for how a DIS should operate, the Council provides the following comments.
Type of institution covered
18. Given that close to 100% of Hong Kong deposits are currently with licensed banks, the Council supports the proposal of including licensed banks in the DIS. This is in line with the current three-tier structure of authorization whereby only licensed banks are allowed to take small deposits. The proposal also matches the policy objective of protecting small depositors.
19. However, the Council queries what effect the HKMA's future plan of converting the current three-tier structure of authorization to a two-tier system will have on the coverage of a DIS. It is assumed that under the proposed conversion plan, licensed bank and restricted license bank (RLB) categories will be maintained as authorised institutions, and the deposit-taking company category will be eliminated. A question arises as to whether RLBs would, as a result of amalgamation under the proposed two-tier structure, be allowed to access small deposits, such as a minimum of $100,000 and whether these deposits would be covered by the proposed DIS.
20. The Council therefore urges the HKMA to consider the issue of deposit protection in conjunction with the review of the three-tier structure of authorization. The Council also suggests that the HKMA keeps under review, the subject of the type of institution covered in the DIS, in light of new developments of banking strategies and changes in consumer behavior that may result from the simplified tier structure.
21. As to including foreign branch banks within the scope of the DIS, the Council fully supports this proposal, given the significant presence of foreign banks in the local retail deposit market. This inclusion would improve the effectiveness of the DIS. In addition, the Council suggests some consideration could be given to ensure foreign banks maintain sufficient assets to meet claims, if an ex post funding approach were to be adopted in the collection of premiums.
Form of participation
22. As stated in previous submissions, the Council considers that mandatory participation in a DIS is crucial. The Council considers that a voluntary system will not provide universal protection to small depositors and may give rise to adverse selection, whereby only riskier banks will choose to join the system. It might also give rise to instability in the banking system as depositors of uninsured banks could transfer their funds to insured banks during a real or presumed impending crisis.
Coverage cap
23. The Council notes from the consultation paper that
- a benchmark for coverage of up to 90% by the number of depositors and at least 20% by the value of customer deposits is generally applied internationally;
- a coverage cap of HK$100,000 would come close to meeting the international benchmark of up to 90% of depositors by number and at least 20% of deposits by value;
- a cap of HK$100,000 would nevertheless be quite low by international standards in relation to per capita GDP; and
- while a cap of HK$200,000 would bring Hong Kong within a comparable range of many major countries in terms of the GDP benchmark, and add a further 7% in terms of the number of depositors covered, this would be at the expense of a higher cost.
24. Having regard to the above, the Council agrees that a minimum coverage cap of $100,000 is appropriate for the scheme at an introductory stage. Nevertheless, the Council urges that a review of the coverage cap should be conducted at a later stage. This subsequent review could also examine other options of compensating depositors. For example, introducing a sliding scale of compensation where a set percentage is met in full and further percentages met to a lesser amount, as practised in a number of other jurisdictions. An option for Hong Kong could be that a 100% compensation cover for the first HK$100,000 is provided and 90% of the next HK$100,000, with a maximum limit of HK$200,000 for an eligible claim.
Basis of coverage
25. The consultation paper queries whether protection should be on an account or depositor basis. The Council notes the observation in the consultation paper that while account-based protection would be simpler to administer, it would encourage depositors to split their accounts within the same bank, thus increasing the administrative costs and eroding the benefits of having a coverage cap. The Council therefore considers that a 'per depositor', per bank, based approach on coverage be adopted.
Netting and exclusion
26. The Council notes that there are a number of categories of accounts already excluded under the current priority payment scheme, which are also proposed to be excluded from a DIS. The consultation paper also proposes that funds booked with foreign branches of Hong Kong banks, and funds secured as collateral, should also be excluded.
27. The consultation paper also notes that over 40% of total customer deposits are held in foreign currencies and that excluding them could render the DIS ineffective. The paper therefore proposes that foreign currency deposits should be included in the coverage.
28. The Council supports the proposed exclusions, and that foreign currency deposits should be covered. However, with regard to the exclusion of the booked amounts of foreign branches of Hong Kong banks, the Council requests the HKMA to study whether banks would encourage depositors' funds to be deployed overseas in order to avoid DIS coverage. For example, as happened some years ago when a number of banks devised a scheme for bypassing the Interest Rate Rule through allowing depositors to use 'swap accounts' to achieve interest rates higher than that allowed under the Interest Rate Rule. The Council is also concerned as to how the authority would deal with assets deployed overseas by foreign branches of Hong Kong banks, when they failed.
Method of Premium Assessment
Customer deposits/covered deposits
29. The Council notes that there is an advantage in using total deposits as the base on which premiums can be assessed. However, under this method of calculation institutions do not pay for protection in proportion to the amount of coverage they receive, and this creates inequality, as certain banks could have a lower proportion of insured deposits relative to others due to their business focus. This would lead to institutions being assessed on a disproportionately higher base relative to the insurance cover they receive. Accordingly, the Council supports the method of premium assessment being on the basis of insured deposits. Risk based, or flat rate assessment of premiums
30. The Council notes the proposal in the consultation paper that it would be more appropriate to introduce a flat rate assessment system, at least in the early stages of the DIS, and then consider a risk-based assessment method at a later stage. The Council has previously made the point that the calculation of premiums in a DIS based on relative risk, will reduce moral hazard and avoid implicit cross-subsidies among banks. The Council is aware that in addition to the difficulties arising from assessing and indicating the level of risk premiums, there is a concern that such sensitive information, substantiated or otherwise, may put the integrity of the banking sector at stake. Nevertheless, it believes as a matter of principle, that consumers should have access to information on risk premiums in order to make an informed choice.
31. Notwithstanding this view, the Council agrees that a fixed rate of assessment of premium could be used in the early stages of development. The option of moving to a risk based premium could be considered after reviewing any possible changes that may have occurred in consumer behaviour and banking practices after a period of time.
