Deposit insurance wouldn’t put credit ratings at risk

There was a curious paragraph in an article by Alex Tarrant on interest.co.nz last week on post-election positioning .  Tarrant was writing about, in particular, fiscal positioning and the possibility that whichever party leads the next government could find its fiscal commitments put under pretty severe pressure because of the policy exepctations of the minor parties (New Zealand First on its own, or in conjunction with the Greens).  He argues that if Labour ends up back in opposition

It will also allow Labour to imply that National must have offered more to Peters on big-spending policies than Labour was prepared to. The hope for Ardern and Grant Robertson would be that National suddenly finds itself being attacked on throwing fiscal responsibility out the window with a set of coalition bribes. And this after the entire campaign was fought by National on sound management of the government’s books and plans to repay government debt to 10% of GDP, from about 23% now.

This could be a huge boost for a resurgent Labour Party even if it does go back into opposition. “We wanted to form a responsible government, but couldn’t get NZ First to agree to responsible spending.”

Labour might even be able to point to how certain policies might have put the government’s credit rating at risk – my understanding is that NZ First’s and the Green’s bank deposit insurance schemes could fit this argument.

The government’s credit rating currently benefits from ratings agencies placing less weight on that government would bail out a failed bank here, with the Reserve Bank’s open bank resolution policy and there being no government deposit guarantee/insurance in New Zealand. If introducing one means rating agencies rethink this position, the argument would be that a lower credit score would lead to higher government borrowing costs. (Peters’ policy on deposit insurance regards majority-owned NZ-registered banks; the Greens want a broader scheme.)

The main bit of the argument didn’t strike me as terribly persuasive –  the warm feeling of fiscal virtue would surely be of little solace to most Labour people on the dark winter nights if they did end up back in opposition for another three years.

But what had really caught my eye was the specific suggestion that New Zealand First or Greens preferences for some sort of deposit insurance scheme might imperil the government’s credit rating.  I’d made a mental note to come back to it, but yesterday someone asked my view on the suggestion, which is the prompt for this morning’s post.

The New Zealand government’s credit ratings are very strong.   There are foreign currency and local currency credit ratings, but for New Zealand only the latter now matter (there is little or no foreign currency debt, and no apparent plans to raise more).  Of the three main ratings agencies, one gives the New Zealand government a AAA rating –  the best there is –  and the other two give the government an AA+ rating, just one notch down.   That makes sense.   We not only have a low level of government debt (per cent of GDP) but successive governments have proved to have the willingness and capacity to keep debt in check when bad stuff happens.  The last time the New Zealand government defaulted on its debt was in 1933 –  and we had lots of company then.

Relatedly, our banking system has been strong and pretty well-managed.  There were some pretty serious problems in the late 1980s, immediately post-liberalisation, particularly with financial institutions that had been wholly government-owned (Rural Bank, DFC, and BNZ).   But since then –  and before that period for that matter –  banks have been pretty strongly-capitalised, and appear to have done a pretty good job of making credit decisions.  Banks took too many risks (were too complacent) in the 2000s around funding liquidity –  and needed a lot of official support on that score during the 2008/09 international crisis period.  But despite a really big credit boom in the 2000s, even a severe recession and quite a slow recovery –  and levels of income (servicing capacity) typically quite a bit below what would previously have been expected –  led to no serious systemwide impairment of the banks’ assets.  Loan losses rose, as they do in every recession, but to quite a manageable extent.   It was a similar story in Australia, Canada and quite a few other advanced countries.  The government put itself on the hook for some finance company failures (through the deposit guarantee scheme) and the ill-advised AMI bailout.  But that was it.

And these days, almost a decade on, pretty demanding stress tests on banks’ loan portfolios suggest that even a savage recession and a very severe fall in house prices would not be enough to topple any of the banks, let alone the system as a whole.  That isn’t grounds for complacency –  in the wrong circumstances lending standards can deteriorate quite rapidly –  but on the sort of lending the banks have been doing over the last decade or two, the banking system itself looks pretty sound.

Rating agencies still worry a bit about the large negative net international investment position of New Zealand (the net claims of foreigners –  debt and equity –  on all New Zealand entities).  Personally, I think that is an overstated concern: the NIIP position has been large for 30 years, but hasn’t (as a share of GDP) been getting any larger.  Mostly it is the net offshore funding of the banking system.   What matters then, from a credit perspective, is the quality of the assets on bank balance sheets (see above).   In my reading of the literature, big increases in banks’ reliance on foreign funding have often been a warning sign (internationally).  That hasn’t been the story here for a long time.

New Zealand is the only OECD country now that does not have a deposit insurance system.   The official rhetoric for a long time has been that depositors need to recognise that they can, and will, lose their money if their bank fails.  It is supposed to promote market discipline.  The Open Bank Resolution tool was devised to try to buttress that “no bailouts” message –  or at least to give ministers options in a crisis.  The OBR is designed to ensure that a bank can be reopened immediately after it fails (thus keeping basic payments services going). It does so through a mechanism that involves “haircutting” the claims of creditors –  the size of the haircut designed to be larger than the plausible, but still unknown actual losses –  while providing public sector liquidity support and a government guarantee to the remaning claims.  Without such a guarantee, rational creditors would mostly withdraw the remaining funds they did have access to as soon as the failed bank reopened.  In practice, since in a small system with quite similar banks all banks are likely to face quite similar shocks, such a guarantee might well need to be extended to the other banks (although I’m not aware that this latter point has ever been conceded by authorities).

It is no secret that governments tend to bail-out failed banks, and often end up offering a degree of protection that goes beyond anything in formal deposit insurance system rules.  That is particular so for retail depositors, but in the last major crisis of 2008/09 it was often true of wholesale creditors too (eg extreme pressure was brought to bear on the Irish government, by other governments and EU entities, not to allow wholesale creditors to lose money when Irish banks failed).

The practice might, in some abstract world, be undesirable, but it happens.    There are some signs now that authorities are putting more effort into trying to build regimes that make it more feasible for wholesale creditors to be allowed to lose money, while not disrupting the continuity of payments systems etc.  But there is no sign of such movement as far as retail depositors are concerned.

And despite the rhetoric, New Zealand’s track record hasn’t been so very different.  Governments twice bailed out the BNZ in the late 80s and early 90s.  The temporary retail deposit guarantee scheme was introduced with bipartisan support in the midst of the 2008/09 crisis.  And AMI –  an insurance company, not even a bank –  was bailed out, on official advice, only a few years ago.    Of course, many small finance companies also failed, and there was no bailout to those depositors.   But a rational retail creditor of a significant retail bank is quite likely to assume that if there is a bank failure, he or she will in the end be protected by the government.

Rational ratings agencies know this too.   In their ratings –  or banks and of sovereigns –  they take account of the probability of official government support.     It is likely to be a matter of serious concern in a shonky banking system, and in a country with high pre-existing levels of government debt.  It isn’t likely to be of much concern in a country with a good track record of stable banking, a low level of government debt, and a good track of reining in fiscal pressures.  And that is true whether or not there is a formal deposit insurance scheme in place.

For a long time I was staunchly opposed to deposit insurance –  like pretty much everyone at the Reserve Bank.  But I changed my mind probably a decade ago.  I’m not so worried by the question of whether it is “fair” or not for ordinary depositors to face the risk of losing money –  there are plenty of other areas where such uncompensated losses happen (eg house prices fall back, or the value of one’s labour market skills drops) –  as by realpolitik considerations:

  • at point of failure, governments are almost certain, whatever they say now, to bail out retail depositors of major core institutions, and
  • a pre-specificed deposit insurance arrangement increases the chances of OBR itself being able to work, and thus of being able to impose losses on wholesale creditors (notably offshore ones).

In an earlier post I outlined a scenario:

Suppose a big bank is on the brink of failure.  Purely illustrative, let’s assume that one day some years hence the ANZ boards in New Zealand and Australia approach the respective governments and regulators, announcing “we are bust”.

Perhaps the Reserve Bank will favour adopting OBR for the New Zealand subsidiary (since the parent is also failing they can’t get the parent to stump up more capital to solve the problem that way).    But why would the Minister of Finance agree?

First, Australia doesn’t have a system like OBR and no one I’m aware of thinks it is remotely likely that an Australia government would simply let one of their big banks fail.  But in the very unlikely event they did, not only is there a statutory preference for Australian depositors over other creditors, but Australia has a deposit insurance scheme.

I’m not sure of the precise numbers, but as ANZ is our largest bank, perhaps a third of all New Zealanders will have deposits at ANZ.

So, if the New Zealand Minister of Finance is considering using OBR he has to weigh up:

  • the headlines, in which ANZ depositors in Australia would be protected, but ANZ depositors in New Zealand would immediately lose a large chunk of their money (an OBR ‘haircut’ of 30 per cent is perfectly plausible),
  • and, even with OBR, it is generally accepted (it is mentioned in the Bulletin) that the government would need to guarantee all the remaining deposits of the failed bank (otherwise depositors would rationally remove those funds ASAP from the failed bank)
  • and I’ve long  thought it likely that once the remaining funds of the failed bank are guaranteed, the government might also have to guarantee the deposits of the other banks in the system.  Banks rarely fail in isolation, and faced with the failure of a major banks, depositors might quite rationally prefer to shift their funds to the bank that now has the government guarantee.

And all this is before considering the huge pressure that would be likely to come on the New Zealand government, from the Australian government, to bail-out the combined ANZ group.  The damage to the overall ANZ brand, from allowing one very subsidiary to fail, would be quite large.  And Australian governments can play hardball.

So, the Minister of Finance (and PM) could apply OBR, but only by upsetting a huge number of voters (and voters’ families), upsetting the government of the foreign country most important to New Zealand, and still being left with large, fairly open-ended, guarantees on the books.

Or, they could simply write a cheque –  perhaps in some (superficially) harmonious trans-Tasman deal to jointly bail out parent and subsidiary  (the haggling would no doubt be quite acrimonious).  After all, our government accounts are in pretty reasonable shape by international standards.

And the real losses –  the bad loans –  have already happened.  It is just a question of who bears them.  And if one third of the population is bearing them –  in an institution that the Reserve Bank was supposed to have been supervising –  well, why not just spread them over all taxpayers?    And how reasonable is it to think that an 80 year pensioner, with $100000 in our largest bank, should have been expected to have been exercising more scrutiny and market discipline than our expert professional regulator (the Reserve Bank) succeeded in doing?  Or so will go the argument –  and it will get a lot of sympathy.

So quite probably there would be some sort of joint NZ/Australian government bailout of the Australian banks and their New Zealand subsidiaries.  The political incentives –  domestic and international –  are just too great to seriously envisage an alternative outcome.

But let’s suppose the Australian government was willing to jettison the New Zealand subsidiary and leave it entirely to us what to do.  The domestic political pressures to protect retail deposits will still be just as real.  In those circumstances, a pre-established deposit insurance scheme (eg for retail deposits up to perhaps $100000 per depositor) would make it more feasible for a Minister of Finance to (a) cap the government’s support, and (b) allow the OBR tool to be applied, under which wholesale creditors would be allowed to lose money.   It still might never happen –  there will still be unease about ongoing access to foreign funding markets for the other banks –  but the option is more feasible than at present (with no deposit insurance in place).  From a fiscal perspective, a pre-specified credible deposit insurance scheme –  funded by a levy, and backed by a credible bank supervision regime –  could actually reduce the fiscal risks associated with a banking crisis, rather than increase them.

Finally, it is worth keeping the numbers in some perspective.  At present, properly defined net Crown debt is about 9 per cent of GDP.    Total (book) equity of all our banks is currently around $37 billion.   Savage stress tests at present suggest little risk of a severe shakeout making material inroads on that buffer.    Banking systems tend not to lose much money on housing-dominated portfolios, when those loans are put in place in floating exchange rate systems without much government interference in the housing finance market.  But lets assume a really savage scenario, in which across the banking system all the equity is wiped out, and 50 per cent more, and the government chooses to recapitalise the banking system.  That would involve  the government assuming additional gross debt of around 20 per cent of GDP.  But much of that would be “backed” by the remaining good assets of the banking system (in time the recapitalised bank could be sold off again) –  it is only the amount the government injects that is beyond replacing existing equity that represents a net loss to the taxpayer.  That amount would be less than 10 per cent of GDP, even on these extremely pessimistic scenarios.   You’ll remember a recent post in which I cited some earlier New Zealand research suggesting that an increase in government debt of that sort of magnitude might raise bond yields by just a few basis points.

Of course, if New Zealand ever did face a really severe shakeout of this sort there would probably be many other problems –  including fiscal ones (tax revenues fall when economies shrink).  The sovereign credit ratings might well be cut.  Not only would there have been huge real losses of wealth within the community, but something very bad would have been revealed about the quality of our banking institutions, our private borrowers, and of our official regulators.  But, again, whether or not we had a formal deposit insurance scheme would almost certainly be a third-order issue in the midst of such a disaster.

At present, with very robust government finances, and a banking system which, to all appearances, is also extremely sound, the choice to introduce a well-structured deposit insurance scheme would be very unlikely to affect the government’s credit rating.   There is an argument that some observers –  rating agencies even? –  might see it as a refreshing dose of realism about how banking crises actually play out, establishing institutions that better respect that realism –  and which charge depositors (through a levy on protected deposits) for the insurance they will, almost inevitably, be provided with.  Priced insurance –  even if imperfectly priced –  is almost always better than unpriced insurance.

And in case anyone thinks deposit insurance is some sort of weird “out there” policy, not only does almost every other advanced country have such a scheme, but a few years ago Minister of Finance Bill English was quite happy to concede, in responding to parliamentary questions from Winston Peters, that there are reasonable arguments to be made for such a scheme (particularly in view of the quite different regimes operating in Australia and New Zealand for many of the same banks).  And he didn’t appear to worry that deposit insurance might threaten the government’s credit rating.

(I’ve argued here that a proper deposit insurance regime increases the chances of OBR being able to be used, especially for wholesale creditors.   My long-held view about OBR hasn’t really changed: it is mainly a tool that could prove quite useful in handling the failure of a small retail bank (eg TSB or SBS), at least if the relevant parliamentary seats (New Plymouth or Invercargill) were not, at the time of failure, held by the governing party.)

12 thoughts on “Deposit insurance wouldn’t put credit ratings at risk

  1. Nice commentary Mike. I agree with the views here and would add that working out a fee, based on RWA’s should be straightforward with the funds then managed by ACC, Guardians of NZ or even the RBNZ.

    The bottom line to me is that while the RBNZ might believe we have a ‘‘market based system’ the reality is that there’s already an implicit wrap – as seen from time to time (most recently AMI and South Canterbury Finance) so preventing there isn’t is disingenuous and simply creates an ad-hoc system subject to the political whims of the day. Finally, talking with ratings agencies, they’re very used to these implicit guarantees and tend to look through any political statements suggesting there’s no guarantee so I doubt that our ratings would move at all in the event we adopt some form of guarantee scheme (which would be designed to support Mum and Dad deposits).

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  2. How would it work in a 1929 style crash? Would the Govt have to try and borrow hard-to-find funds from offshore to pay out the depositors their full amount? While other asset holders see their wealth evaporate.

    Not that I am suggesting the current central banks policies to save the world by creating the ‘everything bubble” will result in a crash like 1929..

    Also I thought a fatal mistake of Cullen’s temporary scheme that cost so much with South Canterbury Finance was the promise to pay 100%. Even a 90% limit would have stopped the rush of funds to get 10% Govt guaranteed returns before they folded. Perhaps a 75% limit keep the banks from getting too reckless?

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    • In the UK, there used to be a 90% limit on the payout from the deposit insurance scheme (with full cover only available for the first GBP 2,000). But it soon became clear with the run on the Northern Rock bank in September 2007 that people would rather queue to withdraw 100% of their money than wait and risk losing 10% of it.

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  3. Of course, in the Great Depression hardly a bank failed in the entire British Empire. Bank failure was largely a US phenomenon (without the diversification options of branch and nationwide banks) and Austria/Germany.

    As you’ll note, mine is a realpolitik response – banks will be bailed out, and especially retail depositors, whether they should or not. In the sort of event you describe, with a floating exchange rate, there is no need for govts to borrow abroad – they issue local currency bonds and if necessary recapitalise by issuing such bonds to the banks in exchange for equity.

    The driver behind the deposit guarantee schemes was fear of panic-runs. If only 75% had been guaranteed then, in that context, anyone with the slightest degree of unease would still rationally pull out everything. in fact, that is what happened in Northern Rock in the UK, where the UK govt had what looked like a good skin, leaving retail depositors with some skin in the game.

    The real prospect of effective market discipline lies with equity holders and wholesale lenders. that is why i put a lot of emphasis on trying to put in place politically-robust mechanisms that make it realistic to expect that wholesale creditors will lose in the event of bank failure.

    In the face of realpolitik constraints, there are no ideal solutions.

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  4. …think it runs counter to the ‘bail in’ policy which, to my mind, should be tested in the first instance; by the time the next crisis rolls round, the deposit taking banks should have on issue sufficient capital instruments that convert to equity – even under severe stress (per tests); creating a DGS sends the wrong signal to those investors that should be disciplining and be disciplined if their judgement is wrong.

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    • The RBNZ isn’t very keen on CoCos.

      But I think where we ,may differen is around the last half phrase and who those particular investors are. I’m not sure it is reasonable to expect 80 year old granny to be doing the disciplining – and better, say, than the RBNZ to whom, as a citizen, she has to some extent delegated monitoring/control – whereas it certainly is reasonable to expect wholesale investors to do so, and to bear the potential consequences if they don’t.

      My motivation is, at least in part, to make it more feasible to enforce losses on those wholesale investors. With OBR alone it just won’t be a credible option – granny and Harvard Endowment take the same haircut – and so a bailout of all creditors is an increased risk (esp if Australia were to be in bailing out mode as well, which has always seemed likely.

      In a way, the issue isn’t pressing for NZ, altho the best term to get dep. insurance going and get some premiums under the belt is when the sun is shining and the (apparent) risks are low.

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  5. …….ah, sorry, to be clear – I don’t expect a grandmother to monitor; an investor in a Tier I, TLAC senior debt security or wholesale money market instrument should be on the hook; to my mind, a DGS provides an inkling that the government might be persuaded to bail out investors over and above retail depositors if there was severe stress; by not offering a DSG, said investors are more likely to think twice about their risk exposure / ask more question of bank asset quality; often think too little attention is paid to the time series development of risk premiums – they seem to go excessively low when risk is high…

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  6. The problem with banks is that they mainly act as intermediaries and earns a margin between transactions. Profits are largely paid out to shareholders in the year it is earned in the form of dividends. Banks therefore are mainly shells. Any major event can cause this delicate balance to domino in a string of bank failures around the globe. Some of the largest transactions is the derivative market which is fundamentally off balance sheet.

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  7. 1) People can insure their houses against loss through insurance policies
    2) People can insure their cars against loss through insurance policies
    3) People can insure, through the use of options, equity shares against loss
    4) Banks can insure against interest rate or exchange rate movements through derivatives
    5) Every other OECD country has a bank deposit insurance policy
    6) It is simply insane that NZ does not.

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  8. Michael
    Insurance increases peoples willingness to take risk. In many ways the GFC arose because risk-sharing arrangements allowed the aggregate level of risk to expand.
    In this context, a scheme for insuring NZ banks could be a plus for NZ-inc if the banks are being too conservative. This could arise if either bank shareholders or bank regulators overvalue risks.
    There seems to be every likelihood that at least the latter is happening with bank regulation.
    The RB is risk averse and appears to be requiring the banks to maintain equity/liquidity buffers beyond what is justified by thorough analysis. In consequence, credit conditions are unduly tight and credit unnecessarily expensive.
    I’m not a believer that regulators are good at regulating risk. Their incentives are lined up to encourage them to be cautious.
    Perhaps a centralized insurance scheme would allow the RB to give the banks greater latitude.
    If an insurance arrangement could provide the banks with “proxy” capital/liquidity at a lower cost than they could source capital/liquidity themselves, that could increase the availability of credit and lower its cost.
    Of course, if the insurance grants the RB even greater powers to limit bank risk taking and increases their sense of responsibility to exercise those powers, it would be counter productive.
    Tim

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    • Interesting points Tim. I’m always uneasy about the potential moral hazard – or the regulatory power grabs that can follow. I guess my concern is that a rational depositor will prudently treat their deposits as, in effect, insured already, and gets that insurance with no ex ante fee. In the process, reliance on oBR seems a bit all-or-nothing,increasing the risk that in a crisis everyone will be bailed out. So the goal of deposit insurance for moderate sized retail deposits is to increase the possibility of effective market discipline thru the wholesale creditors.

      Will it work? I’m not sure, but the starting point for these discussions probably has to be the real world likelihood of bailout, not the world the RB would like us to be in (no bailouts, and no expectations of them).

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