It has been ten years since the global financial crisis. Over this period, a host of new banking regulations have been introduced into the financial system. Some argue there should be more, while others argue it is already too cumbersome. This back and forth is likely to remain a permanent facet of the banking sector, dependent on where you are sitting. Either way, it is undoubtedly true that at the very least compared to 2008, the international banks are far better capitalized, more restricted in the types of activities they can conduct, and the banks themselves have their more esoteric and high-risk functions quarantined off from the typical main-street banking and lending activities.
However, bank failure is always possible. Despite the fact that Hollywood has put out no less than six blockbuster films about the financial crisis, when asked, many people still have a difficult time explaining or understanding precisely what happens when a bank fails, why it fails in the first place, and what happens to their cash savings and deposits.
To understand what happens when a bank fails it is important to know what a bank is and how it operates. At its root level, a bank receives deposits from depositors (you), to whom the bank pays interest (although as we all know, interest rates on Japan bank deposit accounts are famously low). After receiving these deposits, the bank then turns around and loans the money out (which could, interestingly, also be to you). Banks lend this money out in the form of mortgages, so people are able purchase a home without having to save up tens of millions of yen to purchase it outright. Banks also lend money to businesses, enabling them to expand their operations and hire new employees; as well as a long list of other products and services focused around lending out the cash from depositors. In return for lending this money out, banks charge interest to the borrower. The difference between the interest paid to the depositor and the interest received from the borrower is the bank’s “spread”, which contributes to their profit, after deducting for the bank’s operating costs, which can be substantial.
The bank’s loaning ability is increased by what is referred to as “fractional reserve banking“. In simple terms, this means that a bank is only required to keep in deposits a fraction of what they are lending out. The principle being that, it is extremely unlikely that all depositors will want to withdraw all of their money at the same time. Because of this, the banks are able to give out loans for far more than they have on deposit. An example bank these days could operate at a 10% reserve ratio, meaning that for every 10 million JPY you have on deposit with them, they can turn around and lend out 9 Million JPY in the form of mortgages and commercial loans, only having to keep the remaining 1 Million JPY (or 10% of the deposit) in reserves.
In addition to the bank’s operating costs, the bank must absorb losses from so called “non-performing loans” (NPL). An NPL is simply a loan in which the borrower has delayed or missed payments, tried to negotiate for reduced payments, or stopped and given up making payments all together. The bank must absorb these losses as if it were no different to an additional operating expense. However, if there are enough non-performing loans, then it can go into insolvency. In as simple terms as possible, bank failure is when people put cash on deposit, the bank lends it out, and then those that borrowed the money from the bank do not pay it back, so the money is gone. The question is: what happens next.
When a bank goes into insolvency and is unable to pay back depositors, what is known as “depositor’s insurance” kicks in. These are the programs that likely everyone has heard about when setting up a bank account in Japan, as well as back in their home country. Here, the Deposit Insurance Corporation of Japan handles the reimbursement of funds to depositors to Japanese financial institutions which go into insolvency. The basic provision is that you are protected by at least 10 Million JPY per person per financial institution (it is worth noting that if you have two accounts with two companies that are part of a single large group institution, then it only counts as one) for deposit accounts that pay interest. Non-interest bearing deposits are protected in full. Some types of deposits are not protected by the DICJ:
-Foreign Currency Deposits
-Negotiable Certificate Deposits
-Money in trust under no guarantee of principal
-Bank debentures (other than safe deposit instruments)
The DICJ is not part of the bank, but is instead a governmental organization as is similar to depositor’s insurance schemes around the globe (for example, the Federal Deposit Insurance Corporation in the US, or the UK’s Deposit Protection Scheme). DICJ member banks pay annual premiums into the insurance program to capitalize the organization for when the relief funds are required. As was the case in the US ten years ago, it is understood that if there is a sufficiently large enough credit event, the Japanese government step in to assist.
It is important to note that this entire discussion revolves around cash deposits with your retail bank. In other words, your savings account with the ATM card. This is not necessarily relevant to your investment accounts. Market driven losses incurred on your investments are not guaranteed by any depositor’s insurance schemes in Japan. For instance, if you pick a stock and the company goes completely bust; as will your invested capital. However, this principal is a double-edged sword that could act in your favor. If a bank goes bankrupt, this does not necessarily mean your portfolio is also wiped out. If you own shares in Coca-Cola (and the shares are held safely by a custodian bank), then just because a retail bank has gone into insolvency does not mean that Coca-Cola is also going to crumble. Of course, a macro-economic event which would cause a bank to go bust would likely also impact Coca-Cola’s ability to sell soft drinks, but the company is still going to be around, and your investment portfolio will still reflect the positive market value of Coca-Cola.