Are banks "special"?

Individual bank failures are mercifully rare.  Banking regulators should focus on ensuring that the damage does not spread through the system.

Are banks just like any other businesses, or are they "special" in some way?  Generally, if a business is badly run, unprofitable, or offers poor value for money, it is likely to close down eventually.  The owner may lose his capital and his employees will lose their jobs, but few other people are likely to shed a tear.  Competitors that are better run should benefit from the increased business that the closure will bring.

But if a bank closes down, more than just the owners and employees stand to lose.  There are two reasons for this.  First,  banks take deposits, and deposits have two important characteristics: 

• They are money.  If a bank closes down and its depositors suffer heavy losses, the total stock of money in the economy and the overall level of economic activity decline.  The failure of a sufficiently large bank or the simultaneous failure of several banks can trigger a depression – similar to what happened in Thailand and Indonesia in 1997-98.
  　

• They represent peoples' savings.  While wealthy people often own very diverse financial assets – such as bonds, mutual funds, real-estate investments – for many less wealthy individuals their bank deposits are often their only savings.  So a bank failure could wipe out their life’s savings.

Secondly, the failure of one bank can affect others.  Unlike many other businesses, banks form a system.  They are members of the payment system through which debts are settled among companies and individuals, and the failure of one bank to meet its obligations in that system could lead to defaults by others.  It can also damage public confidence in all banks, or at least trigger runs on banks that are perceived to be similar to the one that has failed.

So banks are "special" in the sense that they can’t be treated just like any other business.  Failure of a bank matters to a lot more people than its employees and owners.  This is the main reason why regulation exists – in the words of the Banking Ordinance – to "provide a measure of protection to depositors" and "promote the general stability and effective working of the banking system."

Regulation provides one level of protection, aimed at reducing the likelihood of bank failure.  Deposit protection provides another level of protection so that, in the unlikely event that a bank does fail, depositors’ money will be protected.  Because large depositors, such as corporations and wealthy individuals, are expected to be more able to assess the banks they are dealing with to determine whether they are financially sound and well-managed, deposit protection coverage is usually limited to a certain level of deposits.  This is an internationally recognised approach to designing deposit protection schemes.  As a result the savings of small depositors will be protected if a bank fails, but not all deposits.  For example, in Hong Kong depositors are protected up to a maximum of HK$100,000.  This would fully protect more than 80% of depositors in a typical retail bank.

Should banks never be allowed to go out of business because they are "special"?  The answer is no.  A world in which no bank was ever forced out of business would be an inefficient one.  If regulators tried to eliminate all risks for depositors, the system would be excessively burdensome and uneconomic.  There would be no dynamism and innovation.  An unintended consequence could be that banks might take on too much risk in the belief that they would be protected no matter how badly their judgements turned out. 

Bank failures should be a natural consequence of a competitive market economy, in which investors and depositors take risks to earn returns.  If a bank miscalculates the trade-off between risk and return, investors and its creditors (including depositors) should expect to lose money.  Participants in financial markets need to understand that all financial products, including deposits, carry some level of risk, and it is not the purpose of regulation to remove risk from the financial system altogether.

Bank failures need to be seen as a normal, if, hopefully, rare part of a dynamic, competitive market economy.  The key is to ensure that when a bank does fail it causes minimal disruption to the rest of the banking system.  Deposit protection helps ensure that bank failures can be handled in an orderly way and potential contagion is minimised.

Of course, I am not saying that members of the public need to worry about the imminent closure of any bank in Hong Kong.  Our banks are well run, well capitalised, liquid, and well supervised.  What I am saying is that we cannot entirely rule out bank failures in an open, free-market economy, especially one that is so open to external factors like ours.

Joseph Yam
18 October 2007

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