Dr Kriengsak Chareonwongsak
Senior Fellow, Harvard University’s Center for Business and Government
Thailand’s financial and banking system may be considered, in my opinion, one of the best innovations in our economic history. In fact, I metaphorically compare it to magic; the initial value of banknotes and coins created by the government is increased many times in demand deposit and savings accounts through our financial system.
Banks or financial institutes manage to do such wondrous things because when they receive deposits, they reserve the bare minimum amount of deposits – as required by law – and lend the rest to debtors, who re-deposit their loans into the banks again, this time with added interest charges. In other words, banks hold less cash reserves than the value of their accounts, which they must repay when depositors want to withdraw.
For this reason, the most important factor in maintaining this fragile financial system is to strengthen the credibility of the private sector in regards to Thailand’s financial system. Just imagine if there were a rumor about one bank’s bankruptcy. If depositors believed this rumor were true, all would rush to the bank to withdraw the total amount of their accounts. Eventually, the bankruptcy rumor would come true and become a self-fulfilling prophecy.
Don’t scoff yet. This same depositor panic took place in the 1930s in the United States, causing the Great Depression that plummeted the USA and Canada into economic despair for some ten years. History repeated itself in Thailand in 1997, when financial and economic crisis shook our society.
Therefore, to strengthen depositor confidence, the American government initiated deposit insurance in 1933 and established the Federal Deposit Insurance Corporation to administrate the system. Milton Friedman, a Nobel Prize economist, rightly observed that private sector confidence toward the banking system dramatically increases after the adoption of deposit insurance. The proof is found in a significant decrease in the number of bank suspensions after the adoption of deposit insurance.
However, economic principles dictate that fully insuring all deposits relieves depositors of any personal responsibility over their own investment decisions, allowing them to engage in risky behavior called “moral hazard,” such as investing all their assets in the financial institute with the highest returns without considering its stability. Thus, the U.S. government does not insure the full amount of deposits. In 1934, it initially insured only 5,000 dollars per deposit account; however, this has been increased to 100,000 dollars now, in accordance with America’s economic growth.
The first chapter of Thai deposit insurance history was written during 1997’s economic crisis, when the government of that time put forward a resolution to fully insure (blanket guarantee) all depositors and creditors of financial institutes. This was done in August 1997 to pull investor confidence in Thailand’s financial sector back from the brink of panic. The Financial Institution Development Fund (FIDF) was also established at that time to administrate it.
After the crisis had abated, the government canceled the insurance for the creditors, in accordance with international custom and aimed at establishing a permanent deposit insurance organization. To fulfill this intention, the government put forward its Institute of Deposit Protection Act.
According to this act, the Institute of Deposit Protection (IDP) would be established. It would be government-owned but neither a bureaucracy nor a state enterprise. Its board would be derived from the Ministry of Treasury, the Bank of Thailand, and from Thailand’s pool of financial, treasury and legal experts. Unlike current deposit insurance, only the first million baht of deposit would be protected under the provisions of the Act. During the initial period, all member banks and financial institutes would be required to render regular payments to the Deposit Protection Fund at a flat rate of 0.4 percent of the total value of their deposit accounts. After the system had been well established, the payment system would be changed to a risk premium rate, which would be set by credit rating companies and would vary according to each bank’s credibility.
The Institute of Deposit Protection Act was approved by Cabinet on November 30, 2004, and was sent to State Council for consideration. Nearly three years later, on August 28, 2007, Cabinet approved the draft Act and sent it to the National Legislative Assembly for debate and approval.
However, the State Council has advised that the liability of the Ministry of Treasury, guarantor of all deposits in financial institutions, be reduced to comply with stipulations in the Public Debt Management Act (PDMA). Yet, if the government insists that the Ministry of Treasury be IDP’s guarantor, the PDMA must be revised.
I agree with the general principle of this draft act. For example, limiting insurance to the first million baht per deposit account will discipline the financial behavior of people with investment assets, who do not diversify their portfolios. They should bear the cost of their own risks. Full insurance would only create a moral hazard in the private sector, when investors maximize their own benefit without weighing their own risks. This would force the government to bear the full weight of their investment decisions.
I also agree that IDP’s board should be derived from various organizations and that less stable financial institutions should pay higher risk premiums. These two steps would decrease the moral hazard of financial institutes and banks. In my opinion, preparing the financial sector for risk premiums is IDP’s first priority.
However, this move could cause some negative effects. The higher the risk premiums, the higher the costs that financial institutions would bear for deposits. This may become an incentive for financial institutes and banks to raise funds from other sources. A decrease in the demand for deposit services could lead to a larger gap in interest rates between deposit rates and loan rates and, finally, depositors may suffer from falling deposit interest rates.
Most importantly, I disagree with the move to place the Ministry of Treasury as IDP’s guarantor. This would only signal to the financial sector that it is still protected by the government. It proclaims that if an institute becomes bankrupt, it will be rescued by the government, the common practice in pre-1997 economic crisis days.
Making the Ministry of Treasury IDP’s guarantor will not decrease the risky behavior of financial institutes, especially that of big banks, who perceive themselves as “too big to fall.” Therefore, this move goes against the original intention of the draft that aims at decreasing risky behavior within the financial sector. In my opinion, the government should not be the guarantor. Financial institutes and banks should take the responsibility for their own risky behaviour on themselves, while the government plays the role of an auditor who stabilizes the IDP and guarantees repayment of private sector deposits should a bank go belly up.
I hope this act will fulfill its original mandate: to strengthen the confidence in Thailand’s financial sector and to decrease risky behavior in all sectors. This will prevent our beloved country from facing the trauma of economic crisis again.
Bangkok Post 28/10/2007