The banking system in the modern world runs on a fractional reserve system. Banks have learned that there is in practice no need to keep liquidity equal to the deposits that they hold. Instead, they can lend out much of their deposits to earn interest.
They also realize that much of the money lent out would eventually be redeposited into the banking system. As a result, they can again loan out part of the loaned money that had returned to the banking system. This is the process behind the “deposit multiplier”. Central banks around the world would set a “reserve requirement ratio” that banks must observe, lest the risk for an implosion due to loss of confidence might become too high.
Because the banking system running on the fractional reserve system is a fact, we all know that if all the depositors decide one day to demand withdrawal of all their deposits, no bank will have the liquidity to meet the demands. An implosion will become inevitable. It is rational and better for depositors to play it safe than to be sorry. For this reason, bank runs have happened from time to time.
We have seen the collapse of several important banks in the US starting in March. The first bank to fail was Silvergate Bank. This triggered a bank run on Silicon Valley Bank two days later. It was quickly taken over by regulators that day. Two days later, Signature Bank was closed by regulators on March 12. Not long after, problems spread to First Republic Bank, the 14th-largest US bank as at the end of 2022, which collapsed notwithstanding a major rescue effort involving a number of major US banks and a $70 billion financing facility provided by JPMorgan Chase & Co. The latter eventually took over the bank’s assets for $10.6 billion.
... Offering fractional protection to amounts over the “full-protection ceiling” ... would vastly improve the business climate, and similarly improve people’s confidence in the banking system. It is important for businesses to know that they and their counterparties will not be held up by bank failures in their ability to meet their obligations.
Because banks are all on a fractional reserve system, deposit insurance is necessary. If deposits are all protected, there will be no need for depositors to follow their survival instincts, and contagious bank runs would never happen. Unfortunately, all the bank deposit insurance programs known of to date are subject to a ceiling. In Hong Kong, currently the ceiling stands at half a million Hong Kong dollars. There is now a proposal to raise the ceiling to HK$800,000 ($102,400). According to the consultation document, the deposit coverage ratio will increase from 88.6 percent to 92.2 percent, and this is higher than the international standard of 90 percent.
The proposed change represents a big improvement over the earlier program, which was itself a big improvement over the original program when bank deposit insurance was first introduced in 2006. At that time only HK$100,000 of eligible deposits was protected.
However, there is a strong case for “fractional deposit insurance” above the “full protection” limit. I have been arguing since 1991 that fractional — say, 80 percent — protection for all eligible deposits above the full protection limit should be the way forward.
The reason why protecting large deposits is necessary is because this will better prevent systematic risks. Typically, businesses, particularly big businesses, need to hold big deposits to meet their day-to-day obligations, which include payment to suppliers and contractors, wages and salaries to employees, interest payments to creditors, and installment payments to honor contracts, etc. In general, HK$800,000 is unlikely to be adequate. If these businesses have difficulty honoring their obligations because all their deposits become inaccessible, a systematic crisis could still break out because employees and suppliers might then fail to meet their own obligations. In principle, businesses can split their deposits across several banks. But having a dozen accounts to pay various different kinds of bills is messy and will increase costs. A bank deposit insurance system that exposes all deposits over HK$800,000 to risks is just not adequate for an international business center like Hong Kong.
An important justification for offering fractional protection to amounts over the “full-protection ceiling” is that, while the benefits are huge, the proposed change is so easy to implement. It would vastly improve the business climate, and similarly improve people’s confidence in the banking system. It is important for businesses to know that they and their counterparties will not be held up by bank failures in their ability to meet their obligations.
Some latest news from the US has made my proposal even more cogent and urgent. On July 21, the Daily Hodl website reported that $78 billion had exited the US banking system in one week. On July 22, the same source reported that US banks were abruptly freezing accounts and halting withdrawals without warning or explanation.
Let us recall that Hong Kong’s last bank failure was the Bank of Commerce and Credit International in 1991. It turned out that the Hong Kong operations were not really underwater, but depositors had to endure years of waiting and anxiety before getting their money back. With fractional deposit insurance for all deposits beyond the full protection ceiling, the depositors of the failed BCCI(HK) would have fared much better.
I have been advocating for fractional deposit insurance over and above the full-protection ceiling for decades. I hope very much that my proposal will be seriously considered this time around.
The author is director of Pan Sutong Shanghai-HK Economic Policy Research Institute, Lingnan University.
The views do not necessarily reflect those of China Daily.