Are our bank deposits protected? You may be wondering after watching images from Greece of people lining up at the automated teller machines. Good news. Yes they are.
But on Aug 11 this year, Thailand's Deposit Protection Agency (DPA) will lower the deposit insurance coverage to 25 million baht from 50 million baht, and again to 1 million baht on Aug 11, 2016. Consequently, the amount of deposits protected under this scheme will shrink from 60% to 55% this year, and fall to only 20% next year.
At first glance, it seems that the change this year will affect only wealthy depositors. But in return, depositors could expect, given a stable economic and banking environment, higher deposit rates, especially from smaller banks.
This attitude reflects a key characteristic among the majority of depositors — they are risk-averse.
Risk aversion is a natural human instinct. It's why people buy insurance as protection against future uncertainty. Risk-averse people prefer certainty even though it comes with a cost.
Paying an insurance premium is like buying certainty, as you transfer the risk to the insurer.
Risk-averse behaviour is also observed in the banking industry. When you want to make, say, a one-year fixed deposit, what is the very first factor that you look at? The interest rate, of course. Currently, one-year fixed-deposit rates average 1.50% at big banks, 1.85% at medium-sized ones and 2% at small banks. The smaller the bank, the higher the deposit rate, because depositors don't like the risk.
Generally, large banks are financially stronger than smaller ones, so depositors in the latter are exposed to a higher degree of credit risk and demand a higher return.
Unfortunately, this doesn't really tell us about the risk appetite of depositors. Even depositors who don't care about the risk as long as the returns are the same will automatically require a higher rate to compensate for higher credit risk anyway. So, we would still see higher rates from small banks.
Thus, to reveal the risk appetite of depositors, the credit-risk premium must be somehow eliminated from nominal deposit rate.
Risk-adjusted deposit rates: Ideally, if there was a measure to represent credit risk, it could be factored into the nominal rate to obtain a more accurate credit-risk-adjusted deposit rate.
In theory, if depositors are risk-neutral, then we should observe equal risk-adjusted deposit rates since the credit risk across banks is now the same, which is nil.
On the other hand, risk-averse depositors would still require an additional premium when they assume the risk. So, if the majority of depositors are risk-averse, we should still see higher risk-adjusted rates in small banks than in large banks.
But what is the measure of credit risk? One of the most widely used tools is the credit default swap (CDS) spread. CDS buyers pay the spread — the price of the CDS — to receive credit protection.
For example, if an investor buys a bond issued by Company A for 1 million baht and wants to eliminate the risk of its default, he could buy a CDS from a seller. The seller may charge a spread of 1%, or 10,000 baht in this case, for five years of protection. If Company A defaults within five years, the CDS seller will cover the losses for the investor.
Unfortunately, there is no active CDS market for most Thai commercial banks. But we have developed a technical model to extract market-implied CDS spreads based on the movement in stock prices of each listed commercial bank. Bloomberg conveniently provides the estimated five-year CDS spread which is based on the probability of default. Intuitively, the higher the probability of default, the higher the CDS spread. Thus, the spreads for small banks are more than for large banks.
Using this approach, we have calculated risk-adjusted one-year fixed deposit rates. And it turns out that the pattern persists where small and large banks are concerned. The average adjusted rate in large banks is 1.31%, compared with 1.53% for their medium-sized peers and 1.76% for small banks.
In other words, Thai depositors are indeed risk-averse.
Lower insurance equals higher deposit rates: Now what will happen when deposit insurance coverage is cut in August? Clearly, depositors whose money is no longer guaranteed by the DPA will have to assume more risk.
As a result, they will require higher risk-adjusted deposit rates. To accommodate the requirement of depositors, banks increase nominal deposit rates to attract funds, providing additional premium for depositors.
The DPA in August 2012 ended blanket coverage of all deposits and set a cap of 50 million baht, affecting around 40% of total deposits. And the consequence? Pretty much in line with our hypothesis. The risk-adjusted one-year fixed deposit rate increased for every bank, though it was higher for small and medium-sized ones. Nominal one-year fixed deposit rates also rose at these banks.
Note that the cut in coverage next month will affect only 5% of deposits, which is relatively small, so any rate adjustment may be minimal.
However, the real test will come in 2016 when coverage will shrink to 1 million baht, affecting one-third of total deposits. As a result, depositors could expect an increase in rates next year. You should be able to see a cut in deposit insurance isn't always bad for depositors, is it?
TMB Analytics is the economic analysis unit of TMB Bank. Behind the Numbers is co-authored by Benjarong Suwankiri and Peerawat Samranchit. They can be reached at tmbanalytics@tmbbank.com