A Return to the "Convoy System" of Financial Administration?: Assessment of the "Payment and Settlement Deposit," a Stepping Stone Toward the Full Introduction of the "Payoff" Limited Deposit Protection System in April 2005

TSURU Kotaro
Senior Fellow, RIETI

Less than a year is left before the full introduction of the "payoff" limited deposit protection system in April 2005. The payoff system, which guarantees the repayment of deposits up to a fixed amount (¥10 million in principal and interest), has already been in place for time deposits, foreign-currency deposits and certificates of deposit (CDs) since April 2002. Come April next year, all the other conventional types of deposits - including ordinary deposits - will shift from the current full protection to the limited protection. In the meantime, financial institutions may now offer a new type of deposit called a "payment and settlement deposit," which will remain subject to full protection even after April 2005. The government decided on the introduction of this new deposit in December 2002 for the purpose of maintaining the stability of settlement and payment functions. At that time, I pointed to the problematic aspects of introducing such a scheme (see "Depositors' Selection of Banks and the Deposit Insurance System," Economic Review, Dec. 13, 2002). In this column, I would like to once again critically review the introduction of the payment and settlement deposit by examining the current state of affairs in which my earlier concerns seem to have materialized.

Problems with the introduction of the "payment and settlement deposit"

The term payment and settlement deposit refers to non-interest-bearing, redeemable-on-demand deposits held in payment and settlement accounts. (Deposits held in current accounts fit this definition but only corporate customers with a high credit standing hold such accounts now.) One of the major problems with the new payment and settlement deposit is the huge cost banks would have to bear in offering it. Banks would have to shoulder the cost of introducing a new computer system and expenses for publicizing the new deposit. But that is not all. They would be obliged to pay deposit insurance premiums at a higher rate on those deposits held as payment and settlement deposits, compared to premiums paid on deposits subject to limited protection. These extra burdens associated with the introduction of payment and settlement deposits are far from negligible, especially for small and medium-sized financial institutions. And this is why the Financial System Council, a government advisory body, concluded that it is not appropriate to mandate that all banks introduce the new deposit in a uniform manner.

As a government policy, however, allowing each bank to choose whether or not to offer such deposits is nothing but "suicidal" (see Economic Review, Dec. 13, 2002). Daring to offer payment and settlement deposits, despite all the costs involved, would be interpreted as an attempt to reassure depositors of the safety of their deposits, even after the full introduction of the payoff system. Such a move, credibly signaling the risk of bankruptcy, is tantamount to a bank's confession of its critical condition. On the other hand, healthy and confident banks would be able to demonstrate their soundness by not offering payment and settlement deposits.

Another critical aspect of the introduction of the payment and settlement deposit is the likelihood that banks would transfer some of the costs involved onto depositors (for instance, in the form of account maintenance fees). If this occurs, a rational response by depositors would be to put their money into an ordinary interest-bearing deposit account - though not fully protected - at a healthy and sound bank. If interest rates rise, then depositors would have an even stronger incentive to be selective when choosing a bank. Given all these circumstances, it is no wonder that banks hesitate to offer payment and settlement deposits. In this regard, it is quite exceptional that Yachiyo Bank, a Tokyo-based second-tier bank, began to offer them on April 20, becoming the first bank to do so.

It has been reported that the Financial Service Agency (FSA) is moving to urge all financial institutions to offer payment and settlement deposits (Nihon Keizai Shimbun, May 2). Regardless of the truthfulness of this particular report, there are also other indications of the old-fashioned "convoy system" of financial administration being revived with the FSA backpedaling on its new principle of respecting individual banks' initiative and judgment. At his inaugural press conference in April upon assuming the post of chairman of the Japanese Bankers Association, Yoshifumi Nishikawa, president and chief executive officer of Sumitomo Mitsui Banking Corp., announced his bank's plan to start offering payment and settlement deposits. The move came at a time when some small and medium-sized financial institutions were said to be clinging to the possibility of yet another postponement of the full introduction of the payoff system. Thus, it might have been the case that the FSA issued "administrative guidance," which is suggestive in form but forcible in effect, to urge major banks to take a lead in offering the new deposit, hoping that such a development would contain weak banks' attempts to lobby for another postponement of the introduction of the payoff system. But such a move - should it have been the case - would have gone against what the regulatory authorities intended when they decided to make it optional, rather than mandatory, for banks to offer payment and settlement deposits.

Unquestionably, the government needs to act resolutely on the planned full introduction of the payoff system in April. At the same time, however, it must reexamine its manner of implementing payment and settlement deposits, which is fraught with contradictions. At the very least, the government should clearly state that the full protection of this type of deposit is a temporary measure. Even if the financial regulatory authorities' tactics of "administrative guidance" were to succeed and all the financial institutions were to agree to offer payment and settlement deposits, healthy and sound banks would be far from enthusiastic in promoting the new deposit to their customers because of the higher deposit insurance premiums they would have to pay on them. Indeed, the new deposit system will likely end up being an extremely expensive pie in the sky, incurring huge system costs but doing no good.

The full and timely introduction of the payoff system as an absolute prerequisite for the proper administering of discipline through bank selection

As is seen abroad, it is not rare for a government to provide full protection over bank deposits as an emergency measure to calm depositors and prevent runs on banks at a time of financial crisis. However, once stability is restored to the financial system, such an emergency measure is usually replaced by partial protection. No other countries - but Japan - have taken a step so far-fetched as to provide full protection over a particular type of deposit or to extend protection to cover part of outstanding inter-bank obligations (funds for inter-bank settlements that are in transfer).

Among the member nations of the Organisation for Economic Cooperation and Development (OECD), for instance, Sweden and Finland implemented full protection over bank deposits in 1992, but shifted to partial protection in 1996 and 1998 respectively. Likewise, South Korea, which implemented full protection in 1998, shifted to partial protection at the beginning of 2001 except for non-interest-bearing deposits in payment and settlement accounts, which had their full protection removed at the end of 2003. Turkey, the only OECD country apart from Japan that maintains full protection over deposits at the moment, has already decided to shift to partial protection from July 2004.

As such, we cannot but admit that the current situation in Japan, where financial policy is being determined based on the narrow perspective of a secluded "financial hamlet," is at great odds with what is considered to be common sense in the rest of the world. With respect to governance in the banking sector, the international consensus is that market discipline - including discipline by depositors - is just as important as regulations and supervision by the financial regulatory authorities. Such a perspective has been incorporated into the Basel Capital Accord, a set of capital adequacy requirements for internationally operating banks. Given such circumstances, the full implementation of the payoff scheme in April 2005 is an absolute prerequisite for realizing the proper administering of discipline through bank selections by depositors. The regulatory authorities should then leave it to individual financial institutions to decide whether or not to offer the new payment and settlement deposits. And whether some banks - those finding no merit in introducing the new type of deposit - can openly assert their policy to opt out, instead of pandering to the regulatory authorities, would be a touchstone to test whether the Japanese banking industry has truly left the convoy-system of financial administration behind.

May 25, 2004

May 25, 2004