Safety Net, Capital Adequacy and Deposit Insurance

Safety net policies are designed to address the potential problems of the fragility of financial systems, including the prevention of bank runs and bank failures. Capital adequacy and deposit insurance are important components of the safety net. On the positive side, safety nets are designed to reduce the incentives for banks to take risks and depositors’ incentives to withdraw their funds. But on the other hand there is an adverse effect of such a scheme. For example the presence of deposit insurance scheme may lead depositors to disregard risks of bank failure. Thereby the deposits are governed by highest interest rates on the basis of risky investments and loans.

Tables 4.12 and 4.13 list a number of variables, which describe the level and nature of capital regulation. It can be seen that Vietnam has very restrictive requirements regarding the amount of capital that a bank must have compared to other countries in the region.

The capital regulatory index for Vietnam is more in line with what is observed in developed countries than in developing countries.

Against this background, the beneficial effects of the newly adopted regulation to strengthen the prudential framework in respect of capital adequacy ratios in Vietnam can

19 For a more in-depth analysis of the NPL problems in the banking sector and the measures proposed to

be questioned. From a theoretical point of view, regulation on capital adequacy can have both positive and negative effects on financial development. Capital requirements may serve as an incentive against engaging in high-risk activities. Yet, negative effects may occur due to the difficulties of regulators and supervisors in setting capital standards that mimic those that would be demanded by well-informed private market participants.

Table 4.12: Capital regulatory variables in South East Asia

Overall capital stringency (0-6) Initial capital stringency (0-3) Capital regulatory index (0-9)

Vietnam 5 1 6

Cambodia 3 1 4

China n.a. 3 n.a.

Indonesia 2 3 5

Korea 5 1 6

Malaysia 1 2 3

Philippines 2 1 3

Thailand 3 2 5

Note: Higher values indicating greater stringency

Source: See Table 2 and The Banking Legislation in Vietnam Decree No. 166/1999/ND-CP (SBV, 2000).

Table 4.13: Capital regulatory variables in a global perspective

Overall capital stringency (0-6)

Initial capital stringency (0-3)

Capital regulatory index (0-9)

Vietnam 5 1 6

Developed countries 4.19 1.85 6.08

Developing countries 3.20 1.46 4.65

Note: Higher values indicating greater stringency

Source: See Table 3 and The Banking Legislation in Vietnam Decree No. 166/1999/ND-CP (SBV, 2000).

Looking at the empirical evidence in this area, Barth, Caprio and Levine (2001a) find no robust relationship between capital regulatory restrictiveness and bank development.

Furthermore the relationship between the stringency of official capital requirements and the likelihood of a crisis is not strong.

As described above safety nets that are designed to deal with the potential problems of financial systems are often subject to critique, and have in many countries been identified as one of the sources to financial fragility (World Bank 2002). Deposit insurance encourages excessive risk-taking behaviour, and in some countries where the relevant regulation and supervision to encounter such behaviour has not yet been fully developed, badly designed safety nets can undermine the incentives of the participants in the financial system. On the other hand deposit insurance schemes provide protection. For example if too many depositors attempt to withdraw their funds at once, an illiquid but solvent bank can fail.

Barth, Caprio and Levine (2001a) do not find a strong link between the generosity of the deposit insurance system and bank development. On the other hand they find a very strong link between the generosity of the deposit insurance system and bank sector fragility. This result is consistent with the view that deposit insurance not only substantially aggravates moral hazard but also produces deleterious effects on bank fragility. The results suggest that the reverse incentives effects from deposit insurance overwhelm any stabilizing effects that these safety nets may also have. Given these results, it is not clear that the implementation of an explicit deposit insurance design in the Vietnamese financial sector will have beneficial effects on bank development. In any case, the results emerging from the Barth et al. study indicate that local analysis of conditions and local adaptation to specific characteristics and conditions are prerequisites for any future thoughts in this direction

4.7 Concluding Remarks

Key points emerge from the comparison of the conditions for and the performance of financial sectors in Vietnam and other countries in the region.

Analysing the competitive pressure in the Vietnamese financial sector, it was found that although Vietnam in recent years has levelled the playing field for new entrants somewhat, there is still much to be done before the Vietnamese banking environment can be characterized as competitive or even partly competitive for that matter. This implies that the Vietnamese government should consider policies that could make local financial markets more contestable.

Given that the concentration in Vietnam coincides with substantial state ownership, one option that could make the financial market more contestable would be to strengthen the

process, starting with the recently completed international audits and the subsequent attempts to address the NPL problem in the SOCBs, which must precede any attempt to recapitalise the major SOCBs (see Chapter 5). Only hereafter would it be realistic to consider any form of privatisation of the SOCBs.

Another approach to making financial markets more contestable, which builds upon the indications that banking sectors in Vietnam and other developing countries tend toward concentration and lack of competition, is liberalizing the comparatively strict entry requirements. In this context it is important to emphasize that any new entry allowed should be gradual, so that the franchise value of local banks does not erode quickly, causing instability and potentially a financial crisis. In addition, Vietnam must maintain some limits on entry for prudential reasons. As a consequence, any liberalization of the entry process must be both managed over time and transparent.

If entry requirements are loosened, evidence from other transitional economies indicates that an increasing number of foreign banks will apply for entry into the Vietnamese market. In this case the beneficial effects of foreign entry are likely to be pronounced in Vietnam, where local banks typically have high overhead cost as and low profitability relative to entrants. The technological and efficiency advantages often harnessed by foreign banks is thus likely to be strong enough to overcome informational disadvantages they may have in lending and/or the ability to raise funds locally. It is, however, very important that the foreign banks are given the opportunity to compete directly with the domestic banks. Foreign entrants should therefore not be directed into the gaps/sectors not served by the domestic institutions but rather compete directly and on equal terms with these. In short, foreign banks should be substitutes to domestic banks rather than complement them. In this context it is, however, also important to take the potential negative effects of increased foreign bank presence into account. This is so, in particular, for the increased risk of financial sector volatility due to the increased exposure to international capital flows and the potential erosion of the franchise values of domestic banks.

Prior to opening the sector to new and most likely more sophisticated entrants, the Vietnamese government must, however, strengthen the capacity and autonomy of the regulatory framework. Our analysis points to the following areas:

• The promptness by which the regulator can or will respond to problems in the financial sector is generally lower in Vietnam than in the other countries in the region. Hence, while Vietnamese legislation is equal to or outperforms that of

other countries of the region, the autonomy and power to rapidly implement these laws is lacking in Vietnam compared to the other countries in the region.

• Moreover, the Vietnamese banking system appears to be very restricted when looking at the type of activities banks can engage in. Banks in Vietnam are generally prohibited from engaging in securities, insurance and real estate markets. Activities, which are permitted or only somewhat restricted in most other developing countries.

• Bank accounting standards in Vietnam are below the average level of developing countries, indicating a regional need for improving the accounting standards. The fact that the same is the case in Cambodia, China and Thailand should not be used as an excuse for not addressing this problem – rather the contrary.

• Finally, it was found that Vietnam has very restrictive requirements regarding the amount of capital that a bank must have compared to other countries in the region.

However, given that recent cross-country research indicates that differences in legal origin continue to help explain the development of financial institutions today, even after controlling for other aspects of the overall framework in which financial sectors operate, it would appear that Vietnam faces a difficult task in reforming the financial system. The reason is that the French legal origin may imply that Vietnam has some institutional barriers, which have to be overcome in an effort to reform the financial sector. The subsequent chapters will look at current efforts to reform central parts/functions of the Vietnamese financial system, namely the State Bank of Vietnam (Chapter 5) and the major SOCBs (Chapters 5 and 6).