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With Japanese banks regaining financial health, the ad hoc regime of full-deposit insurance is about to end. Beginning April 1, deposits will be protected only up to 10 million yen in principal plus interest — the same limit that was in force until 1996 when it was removed temporarily amid growing instability in the banking sector. The keyword is risk.

For depositors, limited insurance coverage means that they need to exercise greater discretion in their dealings with banks. For banks and their corporate clients, it signals keener competition in the banking world. As Bank of Japan Gov. Toshihiko Fukui puts it, “We’re not going back to the perfect, peaceful world of the past in which no financial institution collapsed.”

To ensure the safety of their money, depositors must be able to distinguish between “safe banks” and “risky banks.” That requires keeping a close watch on how banks are managed. One basic rule for deposit safety is this: If you see increasing risks at your bank, move part or all of your money to a safer bank.

Large banks, which have drastically reduced their nonperforming loans over the past several years, are now in fairly stable condition. At the end of September 2004, their average ratio of bad loans to total lending was down to 4.7 percent. By contrast, the ratio for regional and community banks remained at a higher 6.3 percent. The reason for this is that small banks find it more difficult than large ones to get rid of bad loans, due partly to their close ties to local clients.

Depositors can evaluate the health of banks on the basis of published information available at bank offices. Three kinds of data are particularly important: (1) the ratio of bad loans to total lending, (2) the ratio of net worth to total assets (capital adequacy ratio) and (3) end-of-term settlement results. A bank doing worse on two of these items bears watching.

Various banks in Japan, large and small, have collapsed over the past decade, but no depositors have suffered direct losses, thanks to blanket deposit protection. Beginning in April, though, the amount of a deposit that exceeds 10 million yen could become worthless in the event of a bank failure.

To allay depositors’ anxiety, a new type of deposit — one designed exclusively for settlement — has been introduced. Money parked in these accounts will be fully protected even if the bank involved goes bankrupt. As of January, 97 percent of the banks nationwide had added or were planning to add these accounts, which do not pay interest, according to the Financial Services Agency (FSA). Among the depositors are local public entities that handle large amounts of taxpayer money.

There is concern, though, that this special privilege of full protection, if granted indefinitely, might neutralize the system of limited deposit insurance. Unlimited protection deprives depositors of a sense of self-responsibility. Reportedly the Bank of Japan wants to see this privilege abolished in the long run.

On the other hand, the full reimposition of the 10 million yen cap has weaker banks worried, and understandably so. The reason is that depositors might shift their funds to stronger banks, just as they did around April 2002 when the cap on time deposits was reinstated. This time around, so far, no marked shift appears to have occurred, perhaps partly because of the introduction of settlement-only accounts and partly because of a better economy over the past three years.

It is worth noting that the prospect of limited-deposit guarantees is spawning moves to promote a variety of higher-yield financial products. Moreover, a dismantling of business barriers among banks, brokerages and insurers, as well as progress on deregulation, is heating up competition in new types of sophisticated products combined with futures and options.

Small investors with little financial knowledge are well advised to deal carefully with these financial instruments. These contracts may look attractive to people anxious to get better returns than today’s rock-bottom interest rates offer or to those planning for a comfortable life in retirement, but they risk losing their nest eggs if they invest without thinking. Caution is in order, particularly for well-off but financially illiterate elderly people, who could more easily fall victim to dubious financial schemes.

The FSA supports legislation — an “investment services law” — to create better conditions for individual investors. The proposed law, if enacted, will expand the scope available for individual investment, possibly including high-risk products such as investment funds.

All in all, the cap on deposit-insurance coverage promises to broaden the range of financial options for individuals as it accelerates the shift from savings to investment. The downside is that risks will increase as investment diversifies.

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