Ordinary account-holders were paid back in those cases from the Deposit Protection Fund (DPF), set up by the government for just this purpose - protecting ordinary citizens' accounts when a bank fails.
But afterwards there were bitter comments from all the main contributors to the DPF - the banks operating in Slovakia. Unfortunately, the issue was not high enough up the political agenda for politicians to introduce changes to the fund system.
However, questions regarding the protection fund were raised. Do we need this kind of fund? What should reasonable protection be?
A healthy financial system is crucial for any economy. It allows a safe flow between savings and investments. If a financial system isn't doing this the whole economy suffers.
In Slovakia almost all external financing of the corporate sector comes through the banks because the capital market is underdeveloped and it cannot issue bonds to raise finance. If we take this into account it isn't hard to see how important the banking system is for the Slovak economy.
But the environment in which the banks operate is a fragile one. Banks take in money mostly from short-term deposits, but they finance investments with longer-term loans. This time gap is making the banking system weak.
Banking everywhere operates on trust - even strong, good banks can go bankrupt if they lose the trust of their depositors. The fall of dominant banks on any market has serious economic consequences. For example, even in the United States, all major economic shocks are connected with bank panics.
Bank failures can of course be caused by mismanagement, especially if banks take on risky investments. Therefore, every state accepts measures that stabilise the banking system. However these measures leave room for inefficiencies linked with moral hazard [defined by economists as "people taking greater risks than they would otherwise do because they know they are protected - ed. note], especially when they have the DPF to back them up.
The question of whether we need deposit protection or not can be best answered through the following example:
Let's imagine we don't have a DPF. If information (it doesn't matter if it's true or not) surfaces that a bank has problems, all its depositors would run straight to the bank and withdraw their savings. The bank would come under enormous pressure and likely collapse.
Even if the bank were to survive, it would face huge losses. The panic would cause the bank to immediately sell all its liquid assets (likely at below market value) to raise funds to settle client demands.
But if the deposit protection fund were there, no such panic would occur. Depositors would not rush so quickly to take out their money because they would have an assurance that they wouldn't lose it. The banks would then get more time to resolve short-term problems and manage the crisis without incurring horrendous costs.
The answer to the question of why we need deposit protection is clear: It prevents runs on banks and bank collapses.
But what are the costs of having this stabilising measure?
The deposit protection fund incurs moral hazard. Both depositors and management of banks are motivated to play riskier games with other people's money. A good example of this was seen in Devín Banka, one of the medium-sized banks in Slovakia.
Although it was clear that the bank had some dubious assets and unsound business practices, depositors preferred to invest there because the interest rates were way above the market average. The logic behind this was clear: If the bank survived, depositors would get above-market returns on accounts. If it collapsed, someone else would pay for it - i.e. the banks contributing to the DPF.
Without deposit protection people would be cautious enough to select a good, healthy bank for their deposits. But deposit protection allows people to speculate and support bad banks.
Bankers generally prefer to take on more risky loans and make a higher profit. Having DPF protects banks and allows bankers to take these riskier investments, potentially destabilising the banking system.
While deposit protection may be a good tool, it must be accompanied by other measures to eliminate moral hazard.
Tomáš Kmeť is a sector analyst with Slovenská Sporiteľňa. His Banking and Finance column appears monthly.
14. May 2001 at 0:00 | Tomáš Kmeť