FOO Law and Economics

Sunday, February 1, 2009

Why the deposit insurance limit should not be raised

Some rural banks have closed, and questions arise as to how this has happened (see, for example, the editorial at a major Philippine daily). One theory is that these failed banks engaged in Ponzi finance, as defined in the theory of financial instability attributed to Hyman Minsky. Another theory is that some of these banks operated a variant of a Ponzi scheme.

Ponzi financing is when the borrower cannot repay his contracted debt (both principal and interest) without having to sell assets or incur new debt. Ponzi financing is not necessary illegal, though Ponzi schemes attended with fraud are (because the fraud is illegal). Ponzi financing may be used by new business ventures, if their start-up capital comes from loans, instead of equity.

A Ponzi scheme, named after Charles Ponzi who left his creditors “holding the bag” in 1920, is one where investors are paid out of money from subsequent investors. A variant of such a scheme, which is bound to collapse, is when the government is forced to bail out its investors.

The essence of a Ponzi scheme is that its operator does not have to earn a legitimate profit to be distributed back to his investors, since new investors are willing to prop up the cash flows of the operation. Obviously, when it works, it is because new investors can be enticed to enter into it, and it collapses when there are no more new investors.

Can a bank do a “Ponzi”? At first glance, it seems that it cannot. Banks are bound to behave responsibly, banking being a business “imbued with public interest.” However, it can do a Ponzi if it operates so that it will fail, leaving its customers whole only through government-mandated deposit insurance.

A bank may engage in a particularly risky operation by promising high interest rates to depositors to attract new funds, when at the same time it cannot find investments that earn a margin over such interest rates. To a new deposit customer, it may look like a “really good deal” if he is promised a 20 percent annual interest return, but is told to stay within the deposit insurance limit of P250,000 “just in case.” In other words, such an operation amounts to a scam against the other banks who pay into the reserve fund of the bank deposit insurer (the Philippine Deposit Insurance Corporation, or PDIC), and against the tax payer if ultimately the capital of PDIC has to be replenished from the public treasury. It is also a scam against other depositors of the closed banks whose deposits are not fully covered by deposit insurance.

There has to be some fraud for the scheme to be a Ponzi, since the bank must allow its books to be examined by regulators. The actual usage of customer funds will have to be concealed from or ignored by the regulators, because a proper accounting would reveal the existence of a Ponzi scheme (the new funds are not used to acquire income-earning assets but simply used to pay interest and support withdrawals by earlier depositors).

What can be done? In my view, the usual bromides (“Know your bank,” and “Bank supervision should be tightened”) are not enough. A possible remedy is to impose an interest-rate ceiling on what deposits earn. Still, this may not work, if “rogue” banks can find ways around the interest-rate ceiling. A remedy being proposed because of the current global crisis – that of raising the deposit insurance limit to P500,000 – is likely to backfire if more banks fail as a result of deposit insurance-based Ponzi schemes.

3 comments:

angela said...

hmm. absolutely, these "rogue" banks should not be able to count on pdic to pay back depositors, that's like rewarding the rogues for their ponzi-like schemes. but what about the big banks, the supposedly stable ones who don't do ponzi schemes. when i opened a time deposit account some years ago - after my sibs and i sold some land left to us by our parents - i was surprised to find that pdic limit was only up to 100k, which is now 250k. i've been hoping matuloy the 500k limit, thou even then i'd lose a lot if my bank got into trouble. i dont really understand why the bank should not be liable for the whole amount. i wonder if i should be withdrawing most of it and keeping it na lang under the mattress ;)

angela said...

take two ;) not that i don't care about the depositors who lost their money, pero di ba dapat habulin these rogue bankers and their huge assets na public knowledge?

Orlando Roncesvalles said...

I understand the BSP is filing fraud cases where appropriate. But the key is prevention rather than prosecution, which is why something like a limit on interest rates on deposits might work.

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