"Hong Kong solution" to bailouts and deposit insurance

"Free-market capitalism transformed Hong Kong from a poverty-stricken victim of the Second World War to its current prosperous condition," notes D.W. McKenzie in an article 'A Move Towards Market Socialism', and Hong Kong is now, or should be, transforming the argument on bank bailouts and the need -- nay, say supporters, the urgency -- of government-backed deposit insurance to put a halt to bank runs on healthy banks.

None of that destructive nonsense for Hong Kong.  When Hong Kong's Bank of East Asia faced difficulties, notes McKenzie, when depositors began to withdraw money en masse, what happened?  Did the Hong Kong government, what there is of it, move to bail it out or guarantee its deposits No, it didn't.  Instead:

    Hong Kong tycoon Li Ka-Shing began buying up shares. This move by Li Ka-Shing helped restore depositor confidence, and rightly so. The Bank of East Asia is well capitalized and has minimal stakes in Lehman and AIG. Of course, Li Ka-Shing made this move for personal profit, but this did help stabilize the financial situation in the Far East. The Hong Kong approach stands in stark contrast to the Bush administration's new policy.

And to the braindead approach taken by the rest of the western world.

Deposit insurance is a short-term solution to a long-term problem, for which as Li Ka-Shing demonstrates, there are much better alternatives.  For despite the illusion of security cast over such schemes, Government-backed deposit insurance is anything but. 

You see, government-backed deposit insurance, which sets up the taxpayer as the fall-guy for something over which they have no control, is inherently risky.

By offering a direct incentive to depositors to prefer riskier institutions with nose-bleed rates of return over safer institutions with more risk-free rates (confident in the knowledge that the riskier profits, if any, will be privatised while losses will be paid for out taxpayers' life savings) deposit-insurance schemes reward the shakier institutions and penalise responsible ones.

The incentives of such schemes are entirely the wrong way round, and are only exacerbated for depositors by the drop in bank savings rates mandated by Alan Bollard yesterday, giving depositors choosing a home for their savings an even greater incentive to "go risky."

Not something you want to hear if "recovery" is what you're after.  Or if repairing or flushing out unsound banks is your concern. Or if you're trying to restore a "liquidity crisis" engendered by a lack of faith in borrowers' ability to repay their debts, and "uncertainty that the balance sheetsof financial firms are credible" -- which the almost legendary Anna Schwarz points out as the cause of today's "liquidity crisis" -- when you know that the incentives all point towards more risk, not less.

And once you've put deposit insurance in place -- no matter how "temporary" you might think it's going to be -- taking it off is like opening Pandora's Box.  It's like taking off a wage-price freeze: all the "temporary" evils squelched by your scheme leap out, and all you're gonna be left with is hope. 'If that hasn't already been destroyed by then.

So government deposit insurance is not the salve so many think it is.

But, I hear you cry, NZ has no tycoons with the wealth to back up local banks in the manner of Li Ka-Shing!  Then more's the pity for us, I say. 

Have you ever asked yourself why we don't?

UPDATE 1:  ANZ-National Bank has just issued the best statement  of its financial health:

"The bank has announced a profit of $1.16 billion saying its New Zealand arm performed well, benefiting from volatility in the global market."

Good for ANZ-National.  Naturally, the unions are whining.

UPDATE 2:  And it doesn't take long for the "Law of Unintended Consequences" to kick in does it.  What to do you think is the result of the unfortunate conjunction of  taxpayer protection for riskier finance companies and Bollard dropping bank rates?  Surprise, surprise: "Investors are “rushing” to finance companies to invest money."  [Hat tip Visible Hand in Economics]

I think I should take up economic prediction.