Banks are supposed to be safe places where one puts hard-earned savings without the fear that the bank will fail. Yet the risk-taking approach of modern banks calls into question the current formula. Current capital reserves of many banks are totally insufficient to cover the potential losses from leveraged trading or the type of derivative trading witnessed at JP Morgan – the latest instalment of a long-running saga.

Rather than hide behind a safety scheme, banks should attract depositors on the strength of their business model- David Curmi

Locally, our banks tend to be more conservative than their European counterparts but risk concentration is present, and the odd maverick bank serves as a reminder of our true European credentials.

We have a safety system though: the depositor compensation scheme which is there to provide a safety net to depositors should a local bank fail. It is financed totally by the banks themselves (not the government). According to the scheme’s annual report as at December 31, 2011, it had reserves of some €11.4 million with a further €53.4 million of assets also committed in the form of a special reserve. This gives it the ability to cover deposits of approximately €65 million, with the possibility of increasing this figure through leverage. The table shows the value of deposits held by banks which have listings on the Malta Stock Exchange.

The problem is actually bigger than first meets the eye.  According to the CBM, total deposits as at May 30, 2012, reached a staggering €23.6 billion. Our two largest listed banks hold some €10 billion in deposits. Although the compensation fund can leverage itself it will never be able to cover these types of figures and, to be fair, it is extremely unlikely ever to be in that situation.

Nor is it expected to cover all these deposits. The scheme covers only what are termed ‘eligible’ deposits. There is a long list of exceptions (see www.compensationschemes.org.mt). In the main, it only covers eligible deposits like a maximim €100,000 per individual in currencies that are issued by EEA countries. GBP is covered, for instance, but USD or AUD are not. In aggregate we estimate eligible deposits to stand at around €9 billion.

There are also other specific rules that are important to note: the fund has the right to set off a deposit versus a loan taken out at the same institution.  Yet the crux of the matter lies with the way the scheme is funded.

Contributions come from licensed banking institutions, calculated as a percentage of the amount of eligible deposits they hold each year. Thus the bigger banks, namely Bank of Valletta and HSBC, fund the lion’s share.  And should the scheme be called on, and there is a shortfall, the gap is filled by other banks. You therefore have a scheme that is funded by the banks to cover each other.

The problem this creates is that it incentivises banks to take risks. Should they fail, it is not them that pick up the pieces but other banks.  A case of heads I win, tails you lose.  So, by investing in BoV or HSBC I could conceivably be taking on other banks’ risks. This is not what the scheme is designed to do – yet in practice this is what it achieves. The acid test about the safety of a bank should come with the answer to the question: if there were no deposit compensation scheme would I deposit money with Bank X?

Rather than hide behind a safety scheme, banks should attract depositors on the strength of their business model. Banks with higher risk models will thus automatically be forced into either being more prudent or paying premium interest rates. The idea therefore that there exists a scheme that has an unlimited liability should a bank fail, without being cognisant of the risk that a bank is taking, is a giant fallacy. Contributions should at least be risk-weighted; at most the riskier banks should be removed from the scheme. Regulators have the power and the knowledge of every bank’s activity to understand where the risks lie.

The need for a Europe-wide deposit insurance scheme is being discussed as countries edge towards bankruptcy. Yet in its current format, the local compensation scheme acts as a risk-transferring mechanism, shifting risk across to other bigger and safer banks.  It is no wonder that the riskier banks use the fact that their deposits are covered by the scheme so prominently in their advertisements.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.

www.curmiandpartners.com

Mr Curmi is managing director of Curmi and Partners Ltd.