The benefits and pitfalls of deposit insurance schemes

Dr Frederic Grant Jr’s forthcoming book uncovers how the US bank deposit insurance system has its root in ideas borrowed from Canton in the 19th century. The origins of the US deposit insurance scheme arose from the 1828 Safety Fund statute of the State of New York, drafted by a legislator named Joshua Forman. In those days, if the state-authorised banks failed, the state would have to pay for their failure. Forman borrowed the idea from Canton that those authorised for privileged trade (in banks the privilege of private currency issue) should be responsible for their own debts.

The success of the New York Safety Fund inspired the adoption of similar schemes by 13 other US states. In 1933, the Banking Act created the Federal Deposit Insurance Corporation, following the failure of many banks across the US. This idea of a national deposit insurance scheme has been adopted by many countries around the world, and is currently being considered in China.   

How did Joshua Forman get the idea about the Canton Guaranty Scheme?  Apparently, New York was already the major port for US-China trade and the scheme was familiar to New York businessmen.  

How did the Canton system evolve?

It all came about because Qing Dynasty official merchants, namely merchant houses (or hongs) authorised by Beijing to conduct foreign trade, often require trade credit to conduct business with foreigners in Canton. If these traders defaulted on their loans, the foreigners threatened to take action against the weak Qing Dynasty. Hence, in order to prevent individual merchant failure, the Qing government used a collective responsibility method evolved by the Manchu court in Beijing, which ensured that those authorised to benefit from the foreign trade also collectively guaranteed each other’s trade debt, and a premium was paid yearly into a fund to pay off any individual failure.    

The Qing government solved the problem of defaults by imposing collective responsibility – everyone was responsible for the group’s debt. The good news was that the group as a whole made sure that no member got into trouble, engaging in what is today called “peer surveillance”. The bad news was that with collective guarantee, the smaller traders had an incentive to take higher risks, creating moral hazard – private gain at collective loss.  Moreover, as history showed, if trade was really bad, more traders failed, and since the Qing government also borrowed from or taxed the accumulated fund regularly, there was not enough money in the fund to settle all debts.  Eventually the Canton Guaranty Fund also failed.

Corruption and misappropriation within the fund was to blame, but the main culprit remained what Grant called “the perennial dilemma of inadequate capital and lack of access to affordable credit” for smaller hongs.

These problems plagued all deposit insurance schemes, and that remains the case even today. Large banks are loath to support deposit insurance because they pay a larger share of the premium than smaller banks. Small banks enjoy the group insurance, but are more prone to failure because they are more likely to take risks, which means that there should be supervision to make sure that these riskier players do not destroy the group as a whole. 

Deposit insurance worked very well in the United States, as the FDIC not only participated in supervision of the insured banks, but also engaged actively as the mortuary of failed banks. In the recent crisis, from 2009 to the present, the FDIC smoothly managed the exit of over 400 banks in the United States, without disruption to the system as a whole. But this time round, it was the failure of the shadow banks and larger banks that created the problem. Yes, smaller banks failed, but they did not take down the whole system because deposit insurance prevented large-scale bank runs at the retail level. 

The time has come for China to adopt a formal deposit insurance scheme.  There are at least three good reasons why it should. The first is that deposit insurance will help stop retail bank panic, exactly the reason for the Canton Guaranty Fund. The second is that there must be an orderly exit mechanism for financial institution failure. Some argue that deposit insurance would duplicate supervision. Today we realise why we have two kidneys instead of one – we need redundancy in the system, in case one fails. The third, based on my personal experience, is that regulators who are good at daily operations may not always be very good at conducting the messy operations of restructuring failed banks. This is a very complicated process that needs strong skills, good bankruptcy laws and more investment banking skills than regulation. Deposit insurance is specialided work and needs specialised skills. 

As Dr Grant rightly said, the historical record of the Canton Guaranty offers valuable lessons for the modern world. “These include: 1) that the tax that supports a guaranty fund must be based on measured risk of loss; 2) that the fund and its insureds must be made subject to strong independent supervision; 3) that laws enacted to avoid risk contingencies must be enforced; and 4) that both corruption and the diversion of fund assets must be strictly prohibited.”   

The trouble with history is that we never seem to learn from history. 

 

Andrew Sheng is president of the Fung Global Institute.