August Introduction

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1 Deposit Insurance To Be Introduced For Banks In Singapore Introduction...1 MAS will be introducing a Deposit Insurance for banks in Singapore. A consultation paper ('Consultation Paper') setting out the rationale, objectives and proposed features of the scheme in Singapore was released on 6 August Proposals on the features of the scheme cover the following matters: membership, coverage, funding, fund size and insured deposit priority, asset maintenance, premium assessment and risk-based pricing. Rationale For Introducing The How The Works Enhancing Depositor Protection Objectives That The Must Meet Key Considerations In Designing The...3 Proposed Structure For The...3 Conclusion...5 Introduction The Monetary Authority of Singapore ( MAS ), the de-facto central bank of Singapore, will be introducing a Deposit Insurance ('') for banks in Singapore. MAS' initial findings have led it to conclude that such a scheme is suitable for Singapore. A consultation paper ('Consultation Paper') setting out the rationale and proposed features of the scheme was released by MAS on 6 August External consultants had been engaged to advise on the insurance fund size and the premium structure for the. Their recommendations are contained in a technical addendum released with the Consultation Paper. The key features of the, as proposed in the Consultation Paper, are as follows: It will cover all Full Banks and finance companies, with membership being compulsory. It will cover Singapore dollar deposits held by residents and non-resident individuals. The coverage will be S$20,000, on a per depositor, per institution basis. A credible ex-ante deposit insurance fund should be established through premium contributions from participating institutions. Priority should be given to insured deposits ahead of other deposits. The insurance fund under the will have a target fund size of 30 basis points of total insured deposits, beyond which premium contributions will be reviewed and reduced if appropriate. Foreign bank branches should maintain sufficient eligible assets located in Singapore to meet their insured deposit liabilities at all times. MAS will monitor compliance through regular reports submitted by banks. The premium assessment base for the will be total insured deposits. The will levy riskbased premiums on member banks based on their supervisory ratings and asset management ratios (in the case of foreign bank branches). Comments from the industry and interested parties are invited on the. The closing date for submissions is 5 September This Update discusses the rationale for introducing the as well as the proposals made in the Consultation Paper. The detailed explanation as to how certain Rajah & Tann, Knowledge & Risk Management June 2002 Page 1

2 choices were arrived at in the design of the discussed in the technical addendum, are beyond the scope of this Update. Rationale For Introducing The Presently, the protection of depositors in Singapore is achieved principally through strong prudential oversight of the financial industry. The key elements of MAS' prudential oversight are strict licensing standards, prudential regulation, risk-based supervision and systemic surveillance. This has resulted in a stable and sound banking system, with the three local banks acknowledged as being well-managed and amongst the best-capitalised in the world, and foreign banks having to meet high prudential standards. It has also given MAS a reputation for being a strict regulator. Given the aforesaid, one would have thought that a deposit insurance scheme was not necessary. So why introduce the now? The answer lies in the increasingly challenging global and regional environment which banks face. This has made the business of banking and risk management more complex. International banks are increasing their scale of operations and venturing into new foreign markets, as well as engaging in new financial activities and products. Singapore-incorporated banks are in turn expanding their commercial presence in the region. These new opportunities for growth and diversification also bring new sources of risk to banks. The above opportunities, in light of the increasing liberalisation of the banking sector, will have greater impact on the banking scene in Singapore. As foreign banks gain greater market share in Singapore and access to domestic deposits, and local banks further develop their presence abroad, the soundness of banks operating here will increasingly be affected by factors beyond MAS' control. The is being introduced in response to these challenges. Moreover, while vigilant supervision can minimise the probability of bank failure, it cannot eliminate the risk of failure entirely. Depositors cannot assume they will always be protected from losses. The will provide a further layer of protection to depositors and complement the role of prudent bank management and MAS supervision in minimising risk. How The Works Under a deposit insurance scheme, depositors are guaranteed compensation of up to a maximum specified amount of their deposits in the unlikely event that the bank they had placed their deposit with fails. The guarantee is typically backed by an insurance fund that is built up through premium contributions from each participating bank, and which will be drawn upon to meet payouts to depositors. Such schemes have been implemented in over 70 countries, including virtually all mature economies. Enhancing Depositor Protection Deposit insurance schemes can enhance the current depositor protection framework by increasing the certainty that depositors will be compensated and providing clarity on the extent of protection and procedure for obtaining compensation. Under the existing regulatory framework, there is no certainty that assets will always be available to meet depositors' claims in the event of a bank failure. This is despite a number of measures already in place, such as requiring Singaporeincorporated banks to maintain paid-up capital of at least S$1.5 billion, having a minimum capital adequacy ratio of 12%, and according, in the event of an insolvency, priority to depositors claim, ahead of other unsecured creditors, over the assets of the bank in Singapore. The amount of assets available may be reduced by asset flight and impairment. Further, many banks operating in Singapore are internationally active and have assets located in different countries, where domestic laws may accord domestic creditors priority over the assets. A deposit insurance fund, built up through contributions levied on participating institutions, ensures that payouts to insured depositors will be independent of whether the banks liquidated assets are sufficient to meet insured deposit claims. Further, an explicit deposit insurance scheme spells out the extent of protection that depositors can expect to receive, which presently is absent under current legislation. Payouts to depositors will also be quicker since the payouts are from a standing deposit insurance fund built up over previous years. Thus depositors can expect to be compensated within a reasonable time. Objectives That The Must Meet MAS has set the following two primary objectives that the must meet: protecting small depositors, and dispelling the mistaken perception of an implicit government guarantee of deposits. Protecting Small Depositors The reason the will focus on the protection of small depositors is not difficult to understand. Small depositors Rajah & Tann, Knowledge & Risk Management Page 2

3 generally lack the ability to exercise market discipline and make informed decisions about which bank to deposit their money with. Yet they are the most vulnerable in the event a bank fails, and hence in need of the most protection. Dispelling The Mistaken Perception Of An Implicit Government Guarantee Of Deposits In Singapore's context, in view of MAS' strong regulatory presence, and in the absence of an explicit deposit insurance scheme, there may arise a mistaken impression among depositors that in the event of a bank failure, the government is there to bail the bank out. By having a privately funded deposit insurance scheme that expressly spell out the extent of protection that depositors can expect, this mistaken belief of an implicit government guarantee should be dispelled. However, the is not intended to be a substitute for caveat emptor and market discipline, and this has to be made clear to depositors. Key Considerations In Designing The In designing the, the following have been the guiding considerations: Cost-effectiveness - Contributions from the participating banks should be kept low, in order not to impose undue costs to banks and depositors as well as not to impair the competitiveness of Singapore's banking system or undermine the financial position of individual banks. Equitable Allocation Of Cost Contributions to the fund should be risk-based so that banks which expose the deposit insurance fund to the largest risk of losses pay higher premiums. Market Discipline - Banks, creditors and depositors should still exercise prudence and market discipline after the introduction of the. To achieve this, the deposit insurance coverage should be clear and limited only to small depositors, and yet afford credible protection so that there is no mistaken expectation of a government bail-out of banks. Proposed Structure For The The discussion on the proposed structure of the covers the following issues: membership, coverage, funding, fund size and insured deposit priority, asset maintenance and premium assessment. Membership It is proposed that participation be made compulsory for all retail deposit-taking institutions. Thus, the will cover all Full Banks and finance companies (references to banks henceforth will include finance companies). Excluded will be Wholesale Banks and Offshore Banks, which do not accept retail deposits. Coverage The will only cover deposits held by individuals, whether they be resident or nonresident. Thus, corporate deposits and inter-bank placements will be excluded from coverage. Further, coverage is to be limited to Singapore dollar deposits held by individuals. Foreign currency deposit accounts are excluded from coverage because extending coverage to such deposits will not benefit small depositors. It is proposed that the covers depositors, rather than each deposit account. This is in line with international practice. By insuring on a depositor basis, a depositor will enjoy deposit insurance coverage on all deposits he maintains with a bank up to the coverage limit. As for the crucial question of coverage limit, this is proposed to be set at S$20,000. Such a limit would fully insure about 86% of depositors. Beyond the coverage limit of S$20,000, the marginal benefit of deposit insurance is very small. For instance, doubling the coverage to S$40,000 insures only an additional 7% of depositors. Funding The Consultation Paper has opted for a privately funded scheme, in line with deposit insurance schemes in all major jurisdictions. The benefit of this is that it allocates the cost of deposit insurance among its beneficiaries. Contributions may be levied ex-ante to build up a deposit insurance fund or ex-post a bank failure. In practice, funding will be a combination of both ex-ante and expost sources, but principally ex-ante because of the advantages of the latter. First, ex-ante funding ensures that a liquid pool will be readily available to make quick payments to depositors. Second, ex-ante funding reduces the degree of cross-subsidisation among banks in the provision of deposit insurance, as the failed bank would also have contributed to the fund. Third, on the premise that bank failures are more likely in a weak banking system, accumulated funds from ex-ante premiums mitigate the pro-cyclical effect that large ex-post contributions can have on banks. Fourth, a credible deposit insurance fund helps to reinforce public confidence in deposit insurance and dispels the expectation of a government bail-out. Rajah & Tann, Knowledge & Risk Management Page 3

4 Soon Choo Hock Executive Partner Contact Details Direct: (65) Facsimile: (65) Fund Size And Insured Deposit Priority In determining the fund size, the consultants used an approach that quantified the potential losses that a fund may bear. The technical details of the approach adopted, which are explained in the technical addendum to the Consultation Paper, are outside the scope of this Update. It is suffice to say that the model used was based upon techniques developed in modeling portfolios of bank loans (ie credit portfolio modeling), incorporates estimates of the probability of default ( PD ) and loss given default ( LGD ) of banks, as well as the default correlations between banks. The Consultation Paper also proposes according priority to insured deposits in respect of claims over an insolvent bank s assets. This would reduce the LGD for those insured deposits, and hence the fund size. A smaller fund size will mean lower premiums for deposit insurance. Uninsured deposits are not expected to be put at a significant disadvantage since insured deposit claims are expected to be relatively small, and would not have a significant impact on asset recovery for uninsured depositors. Thus, by according priority to insured deposits, an effective depositor protection can be provided with a modest fund and at low cost. A target fund size is proposed to be set, beyond which premium contributions can be reduced or reviewed as appropriate. The proposal is for the target fund size to be set at 30 basis points of insured deposits or an estimated S$120m. While this may be modest by international standards, it can offer strong assurance in light of the recommendation for insured deposits to have priority. Further, it will cover losses of institutions of all sizes and achieve a solvency standard equivalent to an investment grade credit rating. To keep prices low, it is recommended that the average annual premium should be three basis points of insured deposits over a year build-up period. Asset Maintenance In order for the to work effectively, banks should maintain sufficient eligible assets located in Singapore. This is a concern not so much with the local banks which are incorporated here, but the foreign banks with only branches here. If a foreign bank branch is wound up, the assets may be repatriated to the head office. Furthermore, cross-border insolvency proceedings can be complex and home country legislation may accord priority to claims in the home country. All this creates more uncertainties in claims on a foreign bank branch assets. Singapore depositors have certainty of claim over only the bank s assets located in Singapore. In order to ensure that there are sufficient assets in Singapore, it is proposed that foreign bank branches maintain sufficient quality assets in Singapore to meet their insured deposit liabilities. They should maintain an asset maintenance ('AM') ratio of 1. Presently, this is being met by a majority of banks and MAS will monitor compliance through regular reports submitted by banks. It is recommended that the following asset types should be counted towards the asset maintenance requirement: Singapore dollar denominated loans and advances to nonbank residents in Singapore, less provisions; Immovable property in Singapore; Core assets less assets used to meet minimum liquid assets and minimum cash balance requirements. Core assets are defined as: Rajah & Tann, Knowledge & Risk Management Page 4

5 o Singapore dollar note and coins; o Singapore Government Securities; and o Balances with the MAS. The consultants have also recommended that banks should be given the flexibility to increase their AM ratios by voluntarily pledging their assets to the deposit insurance fund. Premium Assessment & Riskbased Pricing Deposit insurance agencies generally specify contributions to the deposit insurance fund as a percentage of the premium assessment base ( PAB ). The Consultation Paper proposes that the total insured deposit base be used as the PAB for deposit insurance pricing. This is seen as being a more equitable basis for premium assessment given that it is a bank's total insured deposits that will determine the actual payouts (and hence potential loss to the deposit insurance fund) to depositors in the event of its failure. In addition, it is proposed that the contributions to the fund be riskbased. Under this system, insured banks are assigned to different contribution categories in accordance with their supervisory ratings and their AM ratios (in the case of foreign bank branches). Each category of banks will be charged a different contribution rate, with banks in the best category paying the lowest rate. The rates will range from 2.5 basis points to 30 basis points. This would mean that the higher-risk banks would contribute more to the insurance fund, thus giving an added incentive to banks to manage their risks better. Conclusion Recognising that the is a major initiative, MAS will actively consult with banks on the design of the to ensure that it is costeffective and equitable. This Consultation Paper represents the first phase of MAS' on-going study. The second phase of the deposit insurance study will focus on implementation details of the, including the structure, organisation and mandate of the administrator, legislation, depositor compensation procedures and public awareness programme. The deposit insurance study is estimated to take another year to complete. Rajah & Tann is one of the largest law firms in Singapore. It is a full service firm and given its alliances, including US premier firm Weil, Gotshal & Manges, is able to tap into resources in a number of countries. Rajah & Tann is firmly committed to the provision of high quality legal services. It places strong emphasis on promptness, accessibility and reliability in dealings with clients. At the same time, the firm strives towards a practical yet creative approach in dealing with business and commercial problems. The information contained in this Update is correct to the best of our knowledge and belief at the time of writing. The contents of the above are intended to provide a general guide to the subject matter and should not be treated as a substitute for specific professional advice for any particular course of action as the information above may not necessarily suit your specific business and operational requirements. It is to your advantage to seek legal advice for your specific situation. In this regard, you may call the lawyer you normally deal with in Rajah & Tann or the Knowledge & Risk Management Group at eoasis@rajahtann.com. Rajah & Tann, Knowledge & Risk Management Page 5