There is no doubt that the Mauritian economy will slow down this year. A likely combination of low growth, rising unemployment, increasing public debt and widening current account deficit would be built into macroeconomic instability. So when the Governor of the Bank of Mauritius, Rundheersing Bheenick, declared in a press interview that it is time to establish a deposit insurance mechanism, his words have aroused suspicions.
According to Mr Bheenick, the global financial crisis can overnight shake the confidence of depositors in banks, but the problem does not arise in Mauritius. Saying this publicly, however, makes it become an issue. The Governor assures us that our banking system remains sound on the ground that there exist three or four solid banks. But what about the other fourteen banks? The failure of a small commercial bank alone can create systemic panic.
Commentators can tell people not to panic, but the regulator only knows the picture. There is no rumour about the closing down of a bank. Yet, any perception of bank bankruptcy should be duly managed by the authorities.
In the balance sheet of a bank, the assets (loans) are the liabilities (deposits) of other banks, and their value depends on the behaviour of the latter. If a bank suffers a loss in its assets value, its capital worth will be diluted. The bank then needs to recapitalise or cut expenditure. Money supply and therefore credit lessen unless the central bank injects cash reserves in solvent banks.
Entrusting money to a bank involves some risk. The decision is dictated by the trust that the depositor places in the bank and by the information that he gleans from it. But small depositors are penalised by asymmetry of information, by lack of analytical skills and by an opportunity cost to consult professionals. On the other hand, big depositors and the bank’s shareholders are supposed to be more conscious of the risks and to have the knowledge, capacity and experience to assess the bank’s creditworthiness. They are the first to put up with the consequences of a bank failure while it is possible to protect small depositors through a deposit insurance scheme.
In an implicit deposit insurance system, government has discretionary powers to cover depositors fully with taxpayers’ money, encouraging banks to practise moral hazard, to indulge in excessive risk lending. In Mauritius, those who have a culture of spending pay indirect taxes more than income taxes. Therefore, what suits our specific environment is an explicit deposit insurance system which sets limits on the coverage and thereby safeguards market discipline.
Membership to such a scheme should be voluntary, and the maximum amount of deposit to be insured specified. Partial coverage reduces government’s financial obligation and relieves stress on public debt. Coverage should exclude depositors capable of monitoring banks’ performance.
Uninsured depositors will exercise discipline in selecting their banks. Instead of paying lip service to good corporate governance, all banks will be obliged to disclose timely and relevant information for assessment of their activities. And external bank audits will have to provide greater reliance on the fairness of financial statements...
A deposit insurance scheme for uninformed depositors is desirable for three reasons. Firstly, it generates positive social externalities for economic agents who find it more costly than advantageous to analyse banks. Secondly, it reduces the risk of systemic bank runs prompted by small depositors who are most tempted to withdraw all their money. Thirdly, it whips up competition by supporting small banks in deposit mobilization against large banks.
Deposit insurance would not come into effect should the authorities explicitly apply a closure rule. A bank fails when its assets have less market value than its liabilities such that its net worth becomes negative. A closure rule, publicly announced, will require the regulator to promptly take corrective actions against a bank before its net worth falls below a positive critical level. The regulatory capital-to-asset ratio must be sufficiently high to protect depositors against bank failure and to limit the losses to shareholders.
According to the Financial Stability Report, the capital-to-asset ratio of Mauritian banks stood at 7% in September 2008 compared to 8% in December 2003. The greater the macroeconomic instability is, the higher the capital-to-asset ratio must be. This ratio, which considers total assets, is a better measure than the Capital Adequacy Ratio which evaluates capital against risk-based assets.
The Bank of Mauritius uses the Capital Adequacy Ratio to indicate that “the banks are well capitalised.” The problem with this methodology is that it seems too difficult to include with accuracy the necessary data into the classification of risks. The risk classes and weightage imposed by the regulator in line with the recommendations of the Basel Committee on Banking Supervision can only be arbitrary. They do not totally capture the overall risks taken by a bank with respect to all its individual activities. Also, they encourage risk arbitrage.
Banks which have great exposure to the export sectors need to increase their capital-to-asset ratio. In fact, the best protection against bank failures is a macroeconomic policy that ensures a stable monetary environment. But the conditions are not quite right with the ongoing monetary easing and the depreciation of the rupee. As inflation creeps in, deposits tend to be short term. The share of rupee deposits with maturity up to 24 months in total rupee deposits shot up to 69,4% in September 2008 from 66% in September 2007.
The sharp depreciation of the Mexican peso in December 1994 undermined the quality of the debt portfolio of Mexican banks and forbade their access to new funds. Banking crises in emerging markets are often preceded by an unsustainable rise in investment financed to a large extent by influx of foreign capital. If history is any guide to our monetary authorities, inflation fighting should remain their central focus.
By Eric Ng Ping Cheun
Director, PluriConseil Ltd