Although South Africa has little reason for alarm when it comes to the stability of its banking system, political risks still loom large and the consequences are difficult to anticipate. This is why a safety net in the form of deposit insurance is so important. And South Africa is one of only a handful of countries in the world not to have it.
The role that deposit insurance plays in the banking world was highlighted at a recent conference on Financial Intermediation in Emerging Markets, hosted by the African Institute of Financial Markets and Risk Management (AIFMRM) at UCT. The keynote address by Manju Puri, J.B. Fuqua Professor at the Duke Fuqua Business School in the US, shed light on deposit dynamics in distressed banks in particular.
Deposit insurance is implemented in countries around the world to protect bank depositors from losses incurred by banks unable to pay their debts. It is widely seen as a system that helps promote financial stability and was put in place in the US following the Great Depression. The US, UK, European countries as well as Canada, all have various deposit insurance systems in place. While the introduction of deposit insurance is intended to provide protection to bank depositors in the event of a banking failure, Professor Puri’s research shows that it can even help prevent a bank from failing.
While data and statistics on failing banks and banks in trouble can be hard to come by, Professor Puri was able to study three banks – two in India and one in the US. The results were quite startling. Her studies show that the actions of depositors had a major influence on how the banks coped in times of stress.
Even though deposit insurance differs from country to country depending on the kind of scheme employed, her research showed that uninsured depositors are more likely to run at the first whiff of trouble at a bank. Insured depositors are more likely to stay with a bank and give it a chance to recover or become more solvent. In one study, Professor Puri found that uninsured depositors were 25 times more likely to run when they received information that a bank may fail.
“What we’ve learnt is that the composition of a bank’s depositors is important in assessing bank fragility.” She added that it was not enough to look at the balance sheet of a bank. “You also have to look at the composition of the underlying depositors. Two banks with the same balance sheet may be differentially fragile if the composition of their depositors varies enormously.”
Meanwhile, there are others who have lamented South Africa’s lack of deposit insurance. In December 2016, an International Monetary Fund (IMF) delegation to evaluate the South African economy recommended the establishment of a deposit insurance system as part of the bigger Financial Sector Regulation Bill, which moves to group-wide supervision under a single Prudential Authority and establishes a new Financial Sector Authority. These are set to be passed early in 2017 and will be followed later by a financial sector resolution bill.
As a matter of fact, South African regulators have been mulling over establishing deposit insurance since the 1980s, but there has not been enough buy-in from the banking sector. Bigger banks balk at the idea as they believe they would be subsidising the risk of smaller institutions that are more vulnerable in troubled times.
Back in 2009, the Reserve Bank’s Financial Stability Review (FSR) said that work had been initiated into developing a South African deposit insurance scheme. But eight years down the line, not much progress appears to have been made.
Traditionally, the South African banking industry has relied on the Reserve Bank to rescue troubled banks as it has done in the past with Saambou in 2002 as well as BoE Bank in the same year. But as Dr Co-Pierre Georg, senior lecturer at UCT’s AIFMRM says, the new financial regulations stipulated by the Basel III Framework, no longer permit the same kind of bailout. This is why he feels a deposit insurance scheme for South Africa is an absolute must-have.
“Establishing a deposit insurance mechanism in South Africa is not optional at this point in time.” says Dr Georg. “Our banks are quite stable and highly capitalized, thanks to their conservative approach to risk management and tight supervision by the Reserve Bank. But South Africa cannot afford to allow the banks to play games and delay the introduction of deposit insurance. We need a sufficiently capitalized bailout fund to prevent bank runs and banks must pay their fair share in capitalizing it. It is crucial that this payment happens upfront with a clear and timely payment schedule,” he warns and adds: "Deposit insurance is a necessary complement to capital regulation and necessary because banks take on substantial risks when they are leveraged. Hence it is mainly the banks who must contribute to deposit insurance."
In its report, the IMF also stressed that more prudential regulation; financial service consumer protection and enhancements to the resolution frameworks are needed in the South African financial sector. The report furthermore states that while South Africa’s economy is projected to recover to almost 1% in 2017, this will be insufficient to keep up with population growth. This is expected to place strain on policies as well as financial institutions.
Dr Georg says while the situation in South Africa may be different to what is seen in the US, Professor Puri’s research on banks in developing countries like India shows that finding a way to establish depositor insurance for South African banks should be a top priority to local regulators and that they should not yeild to banks' demand for government support.
“With new financial sector regulations on the way for South Africa in 2017, deposit insurance is hopefully in the cards as well.”