Commercial Banks: How To Achieve Deposit Safety and Operational Credibility

After the restoration of independence in 1990, Lithuania created a two-tiered banking system, comprising a central and commercial banks, under which banks of all sizes and specialisations began to spring up. By late 1995 the Bank of Lithuania had registered 27 commercial banks. Yet, reliance on superficial regulatory rules coupled with a number of weaknesses in the operational principles had adverse effects on the rapidly developing banking sector.
In 1994 through 1995 three dramatic banking crises stunned the nation, first wiping out small banks, then the country’s two largest banks and finally devouring an enormous state-owned bank. In late 1996 there were only 12 banks in operation. People’s losses incurred as a result of the crises were enormous.
When the first bank failures exposed weaknesses in the banking system, the central bank’s response was to institute all kinds of safety schemes. It relied on heavy-handed, short-sighted safeguards, failing to get to the root of the faulty bank operation. Bank supervision was tightened up and deposit compensation schemes were installed. These measures, however, were to fail, for it was not weak supervision or inadequate prudential standards that were at the heart of the banking problems. Their roots stemmed back to the deficiencies inherent in the banking principles.
In response to the need to amend bank law, the Lithuanian Free Market Institute (LFMI) worked out principles of sound banking and submitted policy proposals at the legislative and executive levels. LFMI warned against the consequences of political lending and urged decision makers to reinforce the basis for responsible corporate governance and information disclosure. The article below presents an overview of LFMI’s recommendations for enhancing deposit safety and operational credibility of commercial banks. The proposals fall into three parts, covering deposit insurance, the principles of account holding, and bankruptcy proceedings.
On Deposit Insurance
LFMI has proposed a voluntary deposit insurance system based on the principles of commercial insurance as well as other measures to increase bank operational safety. Lithuania is about to introduce mandatory deposit insurance, a scheme aimed at enhancing operational security of banks and providing guarantees for part of depositors. The scheme relies on state budgetary financing and mandatory participation, disregarding the rules of commercial insurance. Research conducted by LFMI showed that the proposed principles of deposit insurance would fail to accomplish the said objectives.
Weaknesses in the Mandatory Deposit Insurance Scheme
Deposit insurance is supposed to safeguard (i) banks from large-scale deposit withdrawal caused by public panic or other external factors; and (ii) depositors from financial losses incurred in the event of bank failure. The mandatory scheme will fail to achieve these objectives, for it covers a negligible share of deposits as well as excludes accounts in foreign currency, corporate current accounts and time deposits. Being pretty mobile, the latter may undermine bank stability to a greater extent than deposit withdrawal caused by residents’ panic. They may also jeopardise social stability, which relies on timely payment of wages and salaries.
Principles of Voluntary Deposit Insurance
Deposit safety would best be guaranteed by a system in which depositors are active, conscious participants taking voluntary decisions about whether or not to insure their deposits and pay insurance premiums. Bank clients-both individuals and legal entities-should be given a right to insure their accounts regardless of their size, type and currency.
Under a voluntary scheme, insurance premiums would be paid by depositors at the expense of future interests and transferred by the bank in advance. This is a mixed deposit insurance system, for banks would credit depositors in paying their insurance premiums. The level of insurance premiums would depend on the term and type of deposits and the bank’s risk ratio. It would also be differentiated based on the assessment of the bank’s compliance with prudential requirements.
Insurance payments would be made only for insured deposits and accounts. Insurance claims would be filed in the event of instituting bankruptcy proceedings against a bank. Upon the insurance settlement, the insurer would acquire the right of recourse to the sum compensated.
Principles of Holding Bank Accounts
Companies and other legal entities have no option but to make all transactions via banks. So far no restrictions have been placed on banks to use assets deposited in corporate accounts in conducting other bank operations or even filling banks’ own needs. Under such circumstances, the holders of current accounts are faced-against their will-with the risk of loss. What is more, their claims are satisfied in the last order in the event of bank failure.
LFMI proposes introducing reserved accounts. Money deposited in reserved accounts would be entrusted to banks for safe-keeping, but not for interest earning purposes, and reserved in the bank’s correspondent account or cash vault. The client would have access to the account on demand and would not belong in the general creditors’ order. Reserved accounts would provide a means to insure against bank risks a hundred percent.
Bankruptcy Proceedings
The Laws on Commercial Banks and Enterprise Bankruptcy fail to provide conditions for creditors to exercise their rights and have their claims satisfied in the event of instituting bankruptcy proceedings against the bank.
On Creditors’ Rights
According to the commercial bank law, creditors’ meetings are not convened in case of instituting bankruptcy proceedings against a bank. The law fails to specify who takes over the rights of the creditors’ meeting and committee. Creditors’ meetings, LFMI concludes, must be convened, for creditors should take part in adopting major decisions.
On Bank Restructuring and Rehabilitation
The commercial bank law states that bankruptcy proceedings may be halted if a bank is under restructuring or rehabilitation. LFMI argues that this may encourage banks to protract the process of satisfying creditors’ claims. Being integral parts of bankruptcy proceedings, restructuring and rehabilitation should not place a barrier to them.
On Satisfying Creditors’ Claims
LFMI suggests that creditors’ claims be satisfied immediately upon the inflow of income and proportionally to the order of claimants. The commercial bank law provides that creditors’ claims may be satisfied only upon the decision of the court to liquidate the bank. The period of time elapsing between the institution of bankruptcy proceedings by court and the court’s decision to liquidate the bank is fairly long. The decision to liquidate a bank may further be delayed because of restructuring or rehabilitation procedures, during which creditors’ claims are not satisfied, either.
According to the law, claims guaranteed with a collateral are satisfied together with the claims of the bank’s liquidator and employees. LFMI argues that pledgees should not be placed in the general creditors’ order, for they are entitled to concrete property pledged to them. LFMI also proposes that the temporal administrator’s salary and administrative expenses be set by the bank’s creditors rather than the court, as is stipulated in the law.
The traditional bank supervision conducted by the central bank is insufficient to provide sound banking principles and reasonable assurance of operational security. Compensations for lost deposits and deposit insurance rest on futile external measures. Bank clients concerned about potential hazards have no possibility to adopt safety measures such as voluntary deposit insurance or reserved accounts. For those, in turn, not anxious about such hazards, the risk of money loss should be reduced by improving bankruptcy proceedings. LFMI thus proposes:
·  instituting a voluntary insurance system instead of a mandatory scheme;
·  prescribing by law the principles of holding reserved accounts; and
·  specifying by law creditors’ rights in the event of bank failure.