Wednesday, March 21, 2012

China should adopt ultra transparency as part of establishing a deposit insurance system

According to a Wall Street Journal article, the governor of China's central bank is urging the creation of a bank deposit insurance system.

If the Chinese government is going to prevent becoming a captive of its banking system, it should make it a requirement for deposit insurance that the bank provide ultra transparency and disclose to all market participants on an on-going basis its current asset, liability and off-balance sheet exposure details.

With ultra transparency, banks are subject to market discipline.  As a result, regulators can step in before a troubled bank incurs more losses than can be absorbed by its equity and unsecured debt holders.

With ultra transparency, it is also impossible for the policymakers and financial regulators to become captive to the banking system by adopting the Japanese model for handling a bank solvency led financial crisis as the losses in the financial system are not hidden.

With ultra transparency, China does not have to start guaranteeing deposits for a bank until market participants have had a chance to analyze all of the exposure details and determined that the bank is solvent.  Otherwise, China risks insuring deposits where the losses that the bank is exposed to already exceed the capacity of its equity and unsecured debt holders to absorb.

Banks that want deposit insurance will be happy to comply with the ultra transparency requirement.  They know that historically ultra transparency has been a sign of a bank that can stand on its own two feet.  To the extent that their banking competitors are unwilling or unable to offer ultra transparency, the banks that do provide ultra transparency gain a competitive advantage:  in this case, deposit insurance.

By combining ultra transparency, access to central bank liquidity and a deposit insurance system, banks can perform an essential function and protect China's real economy from the losses on any excesses in the financial system.

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