Legal Regime of Deposit Protection in Pakistan

LEGAL REGIME OF DEPOSIT PROTECTION LEGAL REGIME OF DEPOSIT PROTECTION IN PAKISTAN By Muhammad Naveed Chohan Advocate High Court, Lahore INTRODUCTION: In recent years, banking instability has emerged as a major problem in the developed and developing countries due to collapse of various banking companies around the world. Despite economic shocks and stress in stock markets, the banking system of Pakistan has shown good performance in 2009. But non-performing loans, presence of foreign banks in market and banking governance issues incite us to form tight legal structure and regulations to protect depositors from any banking default. According to one view deposit protection law is a major component of financial system safety net that promotes financial stability. But on the other hand it is also criticized because this scheme introduces a moral hazard issue, encouraging both depositors and banks to take excessive risks.' This paper covers the legal regime of deposit protection in Pakistan. First part describes the need of deposit protection law and rise of an explicit system in current scenario. Second part briefly deals with the historical overview about the emergence of deposit protection. Third part presents an analysis of proposed law of Deposit Protection Fund (DPF) in Pakistan. Final part concludes this paper by summarizing all parts. NEED OF DEPOSIT PROTECTION LAW AND RISE OF AN EXPLICIT SYSTEM Deposit protection law protects depositors from losses in the event of bank failures and gives the nation a formal and consistent mechanism for resolving failing bank situation. Such compensation schemes are justified on the basis that they enhance customer confidence. Deposit protection scheme (DPS) makes clear that, banks are now privately owned and that depositors are no longer are guaranteed by the government2. Protecting the safety of small uninformed depositors is a major criterion for the enhancing deposits mobilization3. In the absence of this law depositors shift their deposits to other countries where deposits are protected. This scheme also expects from depositors to remain careful in the placement of their deposits. This scheme is important for banks to discourage runs on banks in trouble. If depositors are assured that they are protected in case of any banking failure, they will not rush to withdraw their deposits. There are two types of deposit protection systems namely implicit protection system and explicit protection system. Both systems have same set of objectives to protect depositors and to maintain a stable banking system. But explicit protection system is considered as better than implicit protection system because in implicit system government has total discretion. Explicit system is likely to produce faster, smoother and more predictable resolution of failing bank situations. This system has predetermined rules of the game and offers better protection to small depositors than implicit system where there is only grantee of deposit protection from government without any set rules. Explicit system is also a useful vehicle for shifting cost of deposit protection to the banking system in the form of required premium. But on the other hand, the desirability of deposit protection is a matter of some controversies. This scheme can create a wrong impression on the banking sector, because customers do not care about their choice of banks and it encourages banks to take greater risks. But these tendencies can be decreased or removed due to effective supervision of bank risks. EMERGENCE OF DEPOSIT PROTECTION: A HISTORICAL OVERVIEW The oldest system of deposit protection is the U.S. system, which was established in 1934 under The Federal Insurance Corporation (FDIC) to prevent the extensive bank runs that contributed to Great Depression4. This corporation was created under the Glass-Steagall Act, 1933. This arrangement got popularity and spread around the globe in the banking industries of other countries. Countries such as Norway, India, Canada and Japan introduced deposit protection schemes in the '60s and '70s. In the UK first time Deposit Protection Scheme (DPS) was introduced under Banking Act, 19795. But, after the introduction of Oxford University Press, 2005, at page 49. Financial Services and Markets Act (FSMA) 2000 all regulatory powers including all operations of DPS were given to Financial Services Authority (FSA). As banking crises escalated, deposit insurance schemes were introduced in many other countries. Banking sector of Pakistan has experienced various ups and downs. Before privatization banks were working under the nationalized or State controlled framework. This framework was introduced under the Banks (Nationalization) Act, 1974. Under this legislation, all Bank deposits were protected by the Government. This system is also referred as implicit protection system. This system has lost its meaning in a situation where most banks are now privately owned and even the largest State owned bank. National Bank of Pakistan (NBP), has private share-holders. Therefore, SBP has decided to form an explicit deposit protection system under proposed law of Deposit Protection Fund (DPF). Explicit system has formal and fixed rules and regulations. It will replace discretionary system with an established legal regimes DPF will be a separate entity as a subsidiary of the State Bank of Pakistan (SBP).7 This body will be formed under above said proposed law. Under section 5 of this law all scheduled banks under the State Bank of Pakistan Act, 1956 shall compulsorily be members of the Fund. DPF will only be required to collect premium payments from member financial institutions, verify depositors' claim in case of bank failure and make payouts accordingly8. ANALYSIS OF NEW LEGAL REGIME OF DEPOSIT PROTECTION Almost all deposit protection laws around the world place a limit on the protected deposit. It gives protection to small depositors and creates confidence. It also preserves some degree of market discipline by exposing large depositors to potential losses. According to drafted law of DPF no such limit is there and only there is promise of compensation to the extent of protected deposits9. It also gives discretionary power to Fund to decide the limit of protected deposits.10This poses two main questions on this law: Is the sole objective of such law to protect small depositors in the event of bank failures? Or it also proposes to protect large depositors. This promise makes the objective of this law unclear. In addition, section 20 relating to determining the size of deposits also makes this issue complex which deals with total amount of member's liability to a depositor, case of joint deposit, deposit in favour of third person and encumbered deposits. This law protects all depositors except as provided in section 19. Protection of foreign currency accounts also places a question on this proposed law. It extends the scope of protection coverage. Various developed countries like Canada do not protect foreign currency accounts to enhance the value of national currency." In addition, default is not only the situation when depositors will be protected under this law. Depositors can be protected when normal operations of a member has been closed or suspended as result of any judicial or regulatory action.12 SBP will issue a notification in this respect.13 Under this draft law, DPF will be a body corporate subsidiary of SBP. There will be five members in the board including Chairman." Deputy Governor of SBP will act as Chairman of Board and three other Board appointments will be made by Central Board of SBP. Fifth member as a Managing Director of Fund shall be appointed by Board of Fund.I5 According to section 11 of this proposed law any employee or Board Member of SBP can be appointed as Board member in the Fund which is totally discretionary authority of SBP without mentioning any qualification for such appointments, term of office and termination of such member.18 This can create major governance issues and conflict of interests because at the same time these members will act as regulator under SBP and Manager of Fund. In addition SBP's power to issue direction to Board under this law17 can create serious problems in corporate governance of Fund. Therefore, there is need to remove these provisions and to include provision of Non-executive Independent Directors' (NEDs) appointment in the Board to eliminate such conflict of interest. Code of Corporate Governance (CCG)18issued by SECP and Hand Book of Corporate Governance (HBCG)19 issued by SBP also encourages NEDs appointments. Authority to form various committees in the Board has also been given under the discretionary authority of Board which is against CCG in which specific committees are required. There is also need to decide on what basis premium will be collected in the fund? Whether risk-based or flat-rate premium will be imposed on member institutions. Risk-based premium are also called varying premiums which are collected according to level of risk taken by financial institution. On the other hand flat-rate premiums are also called simple premium which are applied on the same assessment rate on all member Institutions. It can be inadequate like in the Philippine where fund showed inadequate resources to meet requirements in the banking failures in 1984 to 1988. Therefore; premium should be varying depending on the overall riskiness of bank. This law also does not indicate whether government wall share the cost of deposit protection. In India, Nigeria and Philippines, for example, the government made an initial capital contribution to insurance fund in order to give system creditability20. In Spain, the Government makes regular payment in the fund21. According to section 25 of this proposed law, it is the duty of every person as public servant in service of fund to maintain the secrecy relating to matters of fund22. If any person fails to do so section 25(2) of this proposed law provides limit of pecuniary as well as penal punishment. But it does not provide, what forum has jurisdiction to punish such person? This draft of law also limits the authority of Courts (including lower and superior Court), tribunal or other authority to not compel the production of any unpublished records. This provision has very wide scope, which put a question mark on rule of law and authority of superior Courts relating to public interests in Pakistan. In addition section 30 of said law also restricts Courts to attach pension of any Fund employees by process of any Court. These provisions can provide open holes of corruption in this Fund. Sections 28 and 37 under this proposed law are contradictory in nature because section 28 indicates that section 58, subsections (1), (2), (3), (4) of the Banking Companies Ordinance, 1962 will be followed in priority payments. But on the other hand section 37 clearly mentions that the Banking Companies Ordinance shall not , apply to Fund. There is need to resolve this contradiction. Conclusion: In the light of above discussion, we can say intention to form this law is very positive to create confidence among depositors. But there is need to make this law very simple because this law is directly relating to public interest. There are various loopholes in this law where elements of corruption can be born. Questions relating to limit of protection, level of premium, governance structure and power of Courts need to be answered. The deposit protection law should not be viewed as a substitute for adequate regulation and supervision. Therefore, improved regulation supervision will be necessary to overcome the moral hazards, which can be created on the introduction of this deposit protection law. 1. Sebastian Schich (July, 2008). "Financial turbulence: Some lessons regarding deposit insurance". Financial Markets trends. OECD, at Page 59 http: /www.oecd.org/dataoecd /32/ 54 /41420525.pdf. 2. SBP, Ten year policy strategy for banking sector reforms, at Page 30, available at http: / iwww.sbp.org.pk/bsd/10YearStrategvPaper.pdf. 3. Ibid. 4. A. Deming et al, Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation, at Page 2, available at www.1.worldbank.oro/finance /assets/images/depins08.pdf. 5. P. Ellinger et al, Ellinger's Modern Banking Law, 4th Ed., Oxford: 6. Draft Deposit Protection Fund (DPF) Act, Section 39, available. 7. Ibid. section 4. 8. See supra n.2, at p.30. 9. See supra n.6, section 5 10. See supra n.6, section 18 11. Deposit Insurance, available at <http://en.wikipedia.org/wildi Deposit-insurance> 12. See supra n.6, section 21 13. Ibid. 14. See supra n.6, section 8 15. Ibid. 16. See supra n.6, section 12 17. See supra n.6, section 23. 18. SECP, Code of Corporate Governance, available. 19. SBP, Hand Book of Corporate Governance, available at <http:// www.sbp.org.pk/about/corp-gov/index.htm>. 20. Talley, Smuel I-I, Deposit Protection in Developing Countries, available at http:/wvvw.allbusiness.com/public-administration/national‑security-international/132986-1.html>. 21. Ibid. 22. See supra n.6, section 25.