Strengthening financial stability through deposit insurance scheme
Correspondent | Friday December 1, 2017 15:00
In the current regulatory environment, are depositors’ funds guaranteed in the likely event that a particular bank goes bust? Do regulators have unambiguous resolution framework that provides for reimbursement of depositors in the event of a bank failure?
These are some of the hotly debated topics in recent times particularly following the global recession. The aftermath of the 2007/2008 global financial crisis has brought with it a plethora of regulations laced with a layer of fees particularly in the banking sector, a phenomenon that is supposedly aimed at minimising idiosyncratic risks in the banking system, with the initial objective of protecting tax payers’ funds used to bail out banks in financial distress.
Since the 2007/2008 episode, regulators have not only focussed their efforts on the asset and the liability side of the balance sheet, but also the equity portion. They have consistently dished out a menu of advanced rules in an attempt to overhaul measurement methodologies used to effectively proxy, with a higher precision, risk quantification on written assets of the banks with a further microscope on off-balance sheet activities.
Constant accounting and regulatory changes remain the biggest threat to the viability of the banking business, with the banking sector arguably leading the pack as one of the most regulated industries, perhaps only after the pharmaceutical industry. Whilst there has been talks and discussions around the implementation of IFRS 9 (the accounting standard is expected to impair banks’ capital adequacy ratios by 60bps and an estimated 18% increase in provisions – topic for another day), the buzz word now in the South African financial markets, and indeed other emerging markets, is deposit insurance scheme (DIS). At a very high level, the DIS refers to the complete set of legal, operational and financial arrangements that should be in place to facilitate efficient, transparent and fast protection and/or compensation of covered deposits in the event of a bank failure.
A little over five months ago, the South African Reserve Bank (SARB), National Treasury and their counterparts proposed an establishment of an explicit deposit insurance scheme for South Africa aimed at creating a safety net framework for deposit holders should the banks fail. This new development followed key findings from the World Bank’s Financial Sector Reform and Strengthening Initiative Programme as well as the reviews from International Monetary Fund’s Financial Sector Assessment Programme. On this basis and in part from the review of South Africa’s resolution framework, and given the failure of several banks in South Africa, the National Treasury and the SARB have decided that the country needs an explicit and privately funded deposit insurance fund that can reimburse depositors in the event of a bank failure or that can assist in funding the chosen resolution option. As reported by the news portal IOL, Saambou was placed under curatorship in 2002 and African Bank (Abil), which did not take deposits, collapsed three years ago after R8.5bn black hole. IOL further states that the core challenges of Abil were that it granted too many loans to people who cold not afford to pay them back. When borrowers failed to honour their obligations, the bank was left with a massive hole in the balance sheet. However, the SARB stepped in to save the bank.
In May this year, the SARB published for public comment, a discussion paper specifically dealing with deposit insurance scheme for South Africa. A process to reach agreement on the funding mechanism of such a scheme is currently being undertaken by officials at the SARB in consultation with the banks, the general public, academics and the banking industry experts. The objective of the exercise is to set up a level playing field where deposit holders could comprehend features of protection afforded to them in the so called “explicit guarantee” and to quell expectations that government will always implicitly protect their deposits in the event of a banking crisis.
In the proposed DIS which is also applicable to all the banks, deposits up to a limit of R100,000 per individual, and up to R100, 000 per all non-financial, non-government entities would be guaranteed. It would be applicable to all types of accounts through an aggregate, single customer view. Essentially this means that if an individual has R70,000 in a cheque account and R30,000 in a savings account at a certain bank, the entire collective amount up to a threshold of R100,000 would be covered under the scheme. The same would apply for that individual’s accounts at another bank, and each respective bank they keep deposits with. In the likely event that a bank enters distress or gets liquidated through insolvency proceedings, depositors’ money would be guaranteed by the scheme. Again, the guarantee means that depositors can withdraw their money even if their bank fails. This assurance is intended to give the customers security about their savings so that in the event of rumours of a bank collapse, they do not run helter-skelter and withdraw their funds haphazardly.
Some of the key features of the proposed deposit insurance scheme are as follows:
• The scheme will be a separate legal entity with its own legislative framework and governance requirements, but it will be physically located in the SARB.
• The scheme will cover bank deposits up to R100,000 per depositor per bank.
• If the scheme does not have sufficient funds to cover deposits, the SARB will provide a funding line to the scheme for emergency funding purposes. This emergency funding will be covered from liquidation proceeds and contributions by the remaining banks.
• Where the owner of an account can be identified easily (for example, single accounts and joint accounts), the scheme will pay out depositors within 20 working days after a bank’s deposit accounts have been closed. It may take longer for the scheme to pay out the holders of accounts who cannot be identified easily (for example pooled accounts).
• It will be compulsory for all the registered banks to belong to the scheme.
• The scheme would be consulted whenever the SARB receives an application for a new banking license.
• The following rules are proposed with respect to deposit coverage:
- Small and medium enterprises (SMEs) are generally covered. Because of the difficulty in distinguishing between SME and non-SME businesses, the recommendation is to cover all private non-financial business entities up to the coverage limit, regardless of the size of their deposits or their legal identity.
- Foreign national’s deposits and foreign currency deposits held at domestic branches of South African banks will be covered.
- Deposits will be covered on a gross basis or net basis. Gross coverage ignores any amounts that the depositor may owe the bank, while net coverage entails deducting from the deposit the amounts borrowed from the bank.
- Deposits at foreign branches and subsidiaries of South African banks abroad will not be covered.
- Pooled accounts will be treated as a single account, except in the case of pooled accounts where professional practitioners hold deposits on behalf of clients.
- In the case of a joint account, each account holder will be covered separately, up to the cover limit. The deposit balance will be split equally between the account holders, unless the underlying documentation specifies a different arrangement.
- The following deposits are excluded from coverage: deposits by banks, deposits by the non-bank private financial sector, including money market unit trusts, non-money market unit trusts, insurers, pension funds, fund managers and other private financial corporate sector institutions, deposits by government and quasi-government related institutions, bearer deposit instruments such as negotiable certificate of deposit (NCDs) and promissory notes (PNs).
The SARB strongly believes the above structure would ensure that the cost of a bank failure, in particular, does not fall disproportionately on the most vulnerable consumers, or those who are least able to protect themselves through diversification, hedging, financial structuring or other sophisticated risk-management measures. It is widely believed that the DIS is a necessary complement to prudential regulation and supervision on capital requirements chiefly because banks take on substantial risks when they are leveraged. In that sense, the banks are required to contribute to deposit insurance by paying their fair share in capitalising the scheme without having to incur further costs, a phenomenon that may negate the intended purpose.
How can it be possible for banks to fund the scheme without necessarily incurring further costs? In a carefully designed strategy, the SARB proposed a partially pre-funded approach for the DIS, with the central bank providing the required liquidity in a payout and additional emergency funding in the event of shortfalls. According to their calculations, the pre-funded portion of the scheme would need to be about five percent of the deposits in the banking sector as it currently stands, which translates into a fund of circa R17 billion which the SARB intends to administer in-house. How this is funded still needs consultation with players in the banking sector, but in order to alleviate this initial funding cost, the SARB is willing to consider lowering the cash reserve requirement (CRR) from the current 2.5% to 2.0% of liabilities, as adjusted, which will release circa R17 billion funding requirement for the DIS.
Once this one-off adjustment is implemented, banks will be required to maintain a CRR of 2.0% and a separate DIS requirement of 5.0% of covered deposits.
A major concern with regards to DIS framework is that explicit deposit protection could result in excessive risk taking by institutions and depositors, otherwise referred to as moral hazard in which banks could engage in risky behaviour knowing that there is insurance cover. Even though regulators could have a hard time singling out moral hazard, banks would remain subject to stringent regulation and supervision in which regulatory penalties would be expected to be imposed on banks that take on more risk.
In Botswana where banks are highly capitalised at a consolidated level and as characterised by less levered balance sheets, and low savings levels, DIS framework might not be an immediate need, but as Basel III regulations kick in, specifically regulatory framework that deals with funding and liquidity requirements (liquidity coverage ratios, net stable funding ratios, and leverage), DIS might be warranted.
Transformation of the deposit franchise from wholesale contractual savings dominated by pension funds and fund managers to more behavioural savings on the part of retail consumers would further put pressure on the need for such a scheme as savings level go up and financial inclusion gets more pronounced. One might argue that local banks can be bailed out by their parent holding companies offshore. However, such a resolution in a wind-up scenario could proof difficult for regulators, especially the validity of the legal recourse.
For example, in the proposed DIS for South Africa, deposits at foreign branches and subsidiaries of South African banks abroad are not covered. Additionally, establishment of more indigenous banks and the exponential growth of savings and credit co-operative societies (SACCOS) would require policy makers to set up and/or review the resolution framework to protect less financially sophisticated depositors in the event of a bank failure, thereby providing a reprieve on tax payers’ funds. As this DIS takes shape in South Africa and other emerging markets, there are so many important lessons to be learnt by regulators, the government, academics and banking sector experts in the discourse of strengthening financial stability.
*The views and opinions expressed in this article are those of the author, and they do not reflect in any way those of the institutions to which he is affiliated.