Insuring Depositors' Riches

Deposit insurance. It seems the dream ticket. If banks crash and savers lose their money, why shouldn't they be compensated? After all, isn't capitalism about hard work, stashed wealth and improving standards of living?


The 1992 "shock" price liberalization all but evaporated ruble savings. They were further dented by the Black Tuesday currency crash. All around the country, the voting masses are telling themselves: "This new system. It's a con. You are cheated out of your money at a stroke." Meanwhile, back in the government, as the electoral heat rises and the banking system starts creaking, intelligent people are telling themselves a lie: "deposit insurance ... deposit insurance ... deposit insurance."


In one of its numerous incarnations, the deeply flawed law "On Insuring the Bank Deposits of Citizens" recently rocketed through the State Duma and a fortnight ago received President Boris Yeltsin's signature. Parliamentary consensus over the bill was no surprise. The anti-reform lobby viewed any form of deposit insurance as a welcome government climbdown in the name of social imperatives. Conversely, pro-reformers told themselves the bill would reduce the political fallout connected with a continued bid for macroeconomic stabilization: Tight financial policy and falling GKO yields bring bank failures as sure as night follows day.


Indeed, at first glance, deposit insurance inspires confidence. It draws funds out from under the proverbial mattress and into circulation. The basic problem, though, is that deposit insurance pushes savings disproportionately toward risky high-return accounts, doing financial stability no favors at all. Moreover, a "federal deposit insurance" model -- under which savers with their money in failing private banks would be compensated by the government -- makes a nonsense of the budget.


Thankfully, the law as it now stands takes some account of the problems. A crucial feature is that it provides a structure allowing banks to accumulate an insurance fund among themselves, regularly chipping into a kitty, rather than relying entirely on the government. If a contributing bank goes bust, deposed depositors are supposed to be reimbursed within a month.


One possible benefit of such a "pooled deposit insurance" model is that the rigors of pooling will make banks more self-selecting. Only operations viewed as "sound" by the industry will be allowed in the "club." In theory, depositors should then move their money away from precarious outfits, and into banks within the insurance scheme.


But this is a theoretical, economic, long-run solution to what is a real, largely political and very immediate problem. Perhaps the only way to minimize bank failures is to encourage small rickety outfits -- accounting for most of Russia's 2,500 commercial banks -- to merge with operations larger, hungrier and more stable. If weaker banks were subsumed by stronger ones, savers' accounts would be transferred automatically. The number of banks would then fall, but without leaving depositors high and dry.


The logical way to encourage banking mergers is to decisively hike charter capital requirements. Figures vary, but by most estimates, charter capital in Russia accounted for a minuscule 2 percent of total bank assets in 1995. In fact, only around 20 percent of all joint-stock banks currently fulfill the Central Bank of Russia's current 6 billion ruble ($1.2 million) charter capital requirement.


Such requirements should not only be set much higher, but should also be imposed "retroactively." Standards now apply only to new entrants, meaning the critical mass of unstable banks remains in business.


There is some hint of these views among the authorities. A week ago the Central Bank released a revised "regulation No. 1," setting net charter capital requirements at $6.2 million by 1999. Inevitably, though, this ruling will have no effect on the current situation.


If the Central Bank is serious about minimizing bank failures, a date should be set by which all banks will have their license revoked unless they make the charter capital grade. At the same time, a public awareness campaign should inform the public of the government's intention, reassuring savers should their local branch merge with a regional banking blue-chip hundreds of miles away.


In addition to raising charter capital requirements, the bank should ease its policy of limiting the credit banks can issue -- a policy originally intended to control inflation. Doing so would require reducing the so-called reserve asset ratio, which determines how much a bank can lend based on the size of its deposits. The size of the ratio is inversely related to how much credit an institution can extend. Although high reserve asset requirements limit the inflationary credits a bank can extend, they also cut into loan interest profits.


The current situation is one where charter capital requirements for commercial banks are low, while reserve asset requirements are high -- between 20 percent of 30-day liabilities and 10 percent of 90-day liabilities since May 1995. These are stiff conditions.


The reverse situation would be preferable: high charter capital, with reserve assets lower. In the West, high reserve assets requirements are an important element of a tight monetary stance. However, the inflation-fighting effects of high reserve asset ratios are swamped in a situation where monthly monetary growth is still prone to double digits. The benefits of high reserve requirements are also questionable in that they mean even the richest commercial banks kick and scream against the necessary precaution of higher charter capital. Moreover, high reserve assets discourage long-term lending.


There may be some danger that if Sergei Dubinin, the Central Bank chairman, were to make a really decisive charter capital move, the powerful banks would find a way to remove him. But this does not seem likely. In fact, the most influential banks would do well out of the deal, recapitalizing themselves on the back of the extra deposits which mergers with smaller banks would bring them. The large banks would also have the most to gain from the pro merger policy and the increased stability which it would bring.


The deposit insurance fund, though passed by law, cannot be activated until the government makes an initial contribution. The benefits of making this contribution are limited. Although deposit insurance seems a way out of a tight corner, the benefits of kick-starting a pooled private fund are merely theoretical in the current Russian reality. More decisive action is required in the banking sphere. This is no time for dreams.