Don’t legislate depositor preference

The government has underway a fairly comprehensive review of the Reserve Bank Act.  The first phase –  around monetary policy –  was pretty narrow in scope, rushed, and has resulted in not very good provisions now about to be legislated by Parliament.  I was always a bit sceptical about Phase 2, partly because of the way Phase 1 was handled and partly because the Minister of Finance had never displayed any particular interest in the issues.

But, for the moment anyway, I’m willing to revise my judgement.  Earlier last month a 100 page consultative document was released, the first of three as the Treasury and the Bank (aided by a somewhat questionable, secretive, independent advisory panel) work their way through the numerous issues involved in overhauling the Reserve Bank legislation and institutional design.

Yesterday, I attended a consultative meeting at The Treasury on the issues in the current document.  It was an interesting group of people and quite a good discussion, although even 2.5 hours is barely enough to do much more than scratch the surface on the wide range of issues in the document –  everything from the role of the Board to regulatory perimeter issues (including whether banks and non-bank deposit-takers should be subject to the same regulatory regime – most people seemed to think so).  Truly keen people can spend their summer preparing written submissions (due in late January).

What was striking –  part of what leads me to provisionally revise my view –  is just how much official resource is being put into this one review.  At yesterday’s meeting there were six members of the review team, and that wasn’t all of them –  and even they only report to their masters in the Reserve Bank and Treasury, many of whom will probably engage quite extensively on the issues. And the process has at least another year to run.  Despite having long championed the cause of reforming the Reserve Bank, I couldn’t help wishing that the same level of resource was being devoted to getting to the bottom of the causes, and compelling remedies, for New Zealand’s astonishingly poor long-term productivity performance.    There is little sign The Treasury has any resources devoted to that issue, the one that has the potential to make a huge difference to the lives of all New Zealanders.

But in this post I wanted to touch on just one specific issue that came up yesterday which surprised quite a bit and worried me quite a lot.   Chapter 4 of the document is devoted to the question of “Should there be depositor protection in New Zealand?”.  Of course, to the extent it adds in value at all, prudential regulation does help the position of depositors (reducing the probability of failure, and limiting the potential chaos if a major failure happens), but New Zealand’s legislation is unusual in that there is no explicit depositor protection mandate (the legislative goals are about the financial system, not individual institutions or their creditors).  Linked to that, we are now very unusual among advanced economies in having no system of deposit insurance.

I wrote about some of these issues, in response to a journalist’s queries, when the consultative document first came out.  But my focus then was on deposit insurance, and in particular on the realpolitik case I see for instituting deposit insurance, to give us the best chance that when a bank gets into serious trouble it will be allowed to fail, and its wholesale creditors –  the ones who really should know what they are doing –  can be allowed to lose their money.   Without deposit insurance, my view is that big banks will always be bailed out.  Perhaps they will even with deposit insurance, but by separating the interests of retail creditors from others, at least political options are opened.

But in focusing on deposit insurance, one thing I hadn’t really noticed in the chapter was the idea of providing depositors with additional protection by legislating depositor preference.  Depositor claims on the assets of a bank rank ahead of those of any other creditors.   Such a provision exists in the Australian legislation –  for Australian depositors.  It was a big part of the reason why New Zealand eventually insisted that Westpac’s retail business in New Zealand be locally incorporated (ie conducted through a New Zealand subsidiary).

To the extent I’d noticed the discussion of the depositor preference option, I’d assumed it was a bit of a straw man, there for completeness perhaps.  Surely, I thought, no one would seriously suggest that New Zealand adopt such a legislative preference.   But, going by the discussion at yesterday’s meeting, it seemed I was wrong and that officials are actually seriously considering this option.   They seem to see it as a complement to a deposit insurance scheme.  I think it would be quite wrongheaded.

In my incomprehension, I asked why  –  starting with a clean sheet of paper – anyone would think legislated depositor preference was a sensible route to consider.  The response seemed to be that it would be a way of reducing the cost of deposit insurance, and increasing the credibility of a deposit insurance scheme.  Both seem weak arguments, especially in the New Zealand context.

One argument sometimes advanced against deposit insurance is that in the event of a systemic financial crisis the cost could be so overwhelming that it would either over-burden public debt, potentially triggering a fiscal crisis, or lead to governments retrospectively walking away from the insurance commitment (simply legislating to not pay out).  In fact, we know that for reasonably governed countries that practical limits on the ability to take on new public debt are not very binding at all.   And we know that New Zealand has (a) very low levels of net public debt by advanced country standards, and (b) a banking system of only moderate size (relative to GDP) by advanced country standards.    Total household deposits with all registered banks are about $175 billion.  Not all of those would be covered by a deposit insurance scheme, even one that capped cover at a relatively high $200000.

Now lets assume something really really bad happens: banks lend so badly over multiple years that when the eventual reckoning happens loan losses are so large that 30 per cent of all bank assets are written off.   This would be absolutely huge –  far far beyond anything in Reserve Bank stress test, for beyond advanced country experience for retail-oriented banks.  But one can’t rule out by assumption utter disasters.  30 per cent of bank assets is currently about $175 billion as well.  There is about $40 billion of equity to run through, and then the creditors start bearing the losses.  Household deposits are about a third of non-equity liabilities, so in this extreme scenario the deposit insurer (and residual Crown underwriter) would face bills of up to perhaps $50 billion (a generous third of $135 billion of losses to be distributed across creditors and insurers).    And remember how extreme this scenario is: it assumes every bank in the system fails, and fails dramatically (not just slightly underwater), and that every household deposit is fully covered by deposit insurance.  In this really really bad, highly implausible scenario the bill presented to the depositor insurer is equal to less than 20 per cent of GDP.

Reasonable people can, of course, differ on whether deposit insurance is a good idea at all, just better than the likely alternative (my view), or something to be eschewed at all costs.  But in no plausible world would even a commitment of 20 per cent GDP overwhelm New Zealand public finances, or cast doubt on the ability of the New Zealand government to honour its obligations.   And none of this takes into account the likelihood that any deposit insurance scheme would be set up funded by insurance levies  Levy depositors, say, 20 basis points a year and you’ll be collecting (and setting aside) $350 million a year.  As I recall it, prudential policy (bank capital requirements) are currently set with a view to expecting systemic crises no more than once in a hundred years (the Governor the other day talked of extending that to once in 200 years).    If the really really bad systemic crisis hits in year 1, the government needs to borrow more upfront (recouped over time by the annual insurance fees).  If the really really bad crisis hits in year 150, there is a large pool of money standing ready, accumulated from those same annual insurance fees.

(Of course, in any scenario in which banks have lent so badly –  and regulators regulated so poorly –  that 30 per cent of all assets are written off, the economy is likely to be performing very badly for a while, and the public finances will be under some pressure anyway.  But those problems are there regardless of the resolution method chosen.)

The other argument I heard advanced for a legislated depositor preference is that it would reduce the cost of deposit insurance.    That might look like a superficially plausible argument, but it is almost certainly wrong in any economically meaningful sense.   Sure, if your bank is funded 50/50 by retail depositors on the one hand and wholesale creditors on the other, the chances that a deposit insurance fund will ever have to pay out to the depositors of that bank, in the presence of legislative preference, is very small (roughly speaking, losses would have to exceed 50 per cent of all the assets for depositors to be exposed to loss –  and thus the deposit insurer).    But if you don’t pay for your insurance one way you will pay for it another way.   If depositors have first claim on bank assets and all other creditors are legislatively subordinated, over time depositors are likely to earn lower interest rates than otherwise (less risk to compensate for) and other creditors more).   It might be hard to show this effect in the case, say, of the big Australian banks, but then no one seriously thinks the Australian government would do anything other than bail out those banks in the event of a crisis.  But we can see the pricing on existing subordinated debt issued by banks around the world – it yields, as you would expect, more than deposits.  It is much riskier.

Of course, it is true that legislating a depositor preference largely shifts the problem from the Crown balance sheet (underwriting the deposit insurer) to those of banks and their creditors.  That might look like a smart thing to do  –  internalising the issue and all that –  but in fact it is a subterfuge: trying to meet a public policy priority (depositor protection) by forcing banks to change their entire business model.  Much better to do things in a direct and transparent way: if you want deposit insurance, charge for it directly, and allow banks to determine how they operate their businesses (funding structures etc) given the insurance levies they face, and the market opportunities.  Doing so also operates more fairly – and efficiently – across different types of banks.  Depositor preference accomplishes nothing at all  in a bank that is 100 per cent deposit-funded, and such institutions should be competing on a competitively neutral basis with other banks with different mixes of funding.

In the consultative document, and again in the discussion yesterday, officials seemed to see a model in which wholesale creditors are exposed to more risk as a “good thing”, conducive to effective market discipline.  I’m with them on that point in so far as people -especially wholesale creditors –  who lend to banks should face a real risk of losing their money.  But depositor preference in effect says that the only way non-depositors can lend to banks is through instruments on which the losses mount extremely rapidly if anything goes wrong.  There is no good case for that (even if, as some do, you think it is reasonable to require banks to issue some tranche of subordinated or convertible debt).   It is a doubly surprising argument to hear mounted in New Zealand where for years –  and especially since 2008 –  we have been repeatedly reminded of the heavy exposure of our banks to offshore wholesale funding markets.   None of those holders has to take on exposure to New Zealand or New Zealand banks.   Legislate depositor preference and what you will do is to significantly increase the risk of those funding markets, for New Zealand, freezing, and yields on secondary market instruments going sky-high, at the first sign of any trouble, or even just nervousness.    Retail runs are one issue to think about, but as we saw globally in 2008 wholesale runs can be just as real, and perhaps more threatening (and lightning fast) –  I discussed the Lehmans story here.

I hope the legislated depositor preference option is taken off the table quickly.  It has the feel of clever wheeze intended to ease the path for deposit insurance.  Much better to make the case –  and there is a sound one –  for a properly funded deposit insurance scheme on its own merits.

On a totally different subject there was a surprising article in the Herald yesterday in which a former MPI official was discussing openly concerns held in 2008/09 about the potential financial health of Fonterra.   I was involved in this work at the time, working at The Treasury, and have always been a bit surprised that there wasn’t more open analysis of the issue at the time.  Just drawing on public information, the combination of:

  • a quite highly indebted cooperative,
  • largely frozen international credit markets (not just for banks),
  • highly-indebted farmer shareholders,
  • a model in which shareholder farmers could redeem their shares in Fonterra when their production dropped,
  • a drought the previous year (reducing production) and
  • low product prices, encouraging some farmers to further reduce production, and
  • the potential for some highly-indebted farmers to be sold up by their banks

was a pretty obvious basis for some vulnerability.    Fortunately, the particular extreme combination of risks never really crystallised.   One aspect of the 2008/09 crisis that was always interesting was –  in the words of one investment bank CEO at the time –  “one of the few markets that remain open is the New Zealand corporate bond market”.  That was because it was, and always has been, primarily a retail market, different from the situation in many other countries (reflecting regulatory differences).  In early 2009 Fonterra was able to run a highly successful domestic retail bond issue.  Subsequent changes to the Fonterra capital structure mean that in future serious downturns, redemption risk is no longer a consideration.  That, however, leaves more of the (liquidity) risk on farmers themselves.

18 thoughts on “Don’t legislate depositor preference

  1. As I have indicated before, the $40 billion banks equity is not available for any savings depositors bailout as it is a historical record and is represented by Assets less Liabilities. You have to look at the quick assets available for a immediate bail out ie Cash and Deposits of $17 billion and Investment in securities of $44 billion.

    Equity is represented by Assets – Liabilities


  2. “Immediate bail-out” is about liquidity, which is a different issue.

    The solvency (and associated issue) are about who has claim on the assets. Equity holders have last firm on the proceeds of asset realisation, and that is what is meant in saying that the first $40bn of loan losses are borne by them. I’m not suggesting equity is in any sense “available cash”.


    • Equity holders are the last in line in the event of a receivership/liquidation as assets on liquidation are usually worth much less than the book value.

      Therefore if loan assets are impaired by $100bn and you want the banks to be viable and continue to trade then you have to top up by at least $100bn and not $60bn. This presupposes that banks would only invest a minimum capital as required by its banking license. Therefore you can’t run a viable bank based on Assets = Liabilities. There is a minimum equity requirement to run a bank in NZ.

      Also not all shareholders have a loss equal to the Equity value in the Balance Sheet. A bank like Kiwibank has 2 other major shareholders that have bought ownership at a market value from the government, which need not be equal to the Equity value shown on the Balance Sheet.. Their loss would be a market value loss rather than an Equity value loss on the Balance Sheet.


      • Therefore for a bank to remain solvent the easiest path is a Greek Haircut on depositors funds to re-establish solvency because there are no winners in a liquidation. A Savings deposit insurance guarantee risks the governments balance sheet.


  3. At the time the Reserve bank was discussing its OBR proposals, I raised the option of Secured Transaction Deposit Accounts – an idea that’s been around in various forms since the Chicago Plan in the 30’s [and revisited by Benes and Kumhoff in 2012 .

    It has the obvious attraction of avoiding the costs of insurance, eliminating “in-flight” problems during a bank failure and allowing a significant simplification and cost reduction in the systems of money transfer. If the banks would agree, it could even take the form of a market driven offering that would avoid any regulatory impost.

    My understanding is that such an instrument has never found bank favour because using “real” money for payment transactions did not have any obvious profitability advantages and (horrors!) might even have reduced barriers to entry for competition in the provision of money transfer systems. I am disappointed to see that it is not in the list of options against deposit insurance and legislated preference alternatives.


  4. I’m confused. What is “Depositor Preference”
    In conventional business lingo preference (preferred) implies ranking of creditors whereas the following RBNZ extract indicates it’s just another term for insurance

    Extract “Unlike many other countries, NZ deliberately does not have a depositor preference or deposit insurance framework. This means that depositors are not shielded from losses in a bank failure. In 2010 the National Government concluded it did not favour a deposit insurance framework”

    Click to access 2013mar76-1hoskinjavier.pdf

    So, after 10 years and many billions of electrons, what’s the story with OBR?
    Has it been shelved


    • The RB extract is talking about two different things: we don’t have deposit insurance and we don’t have statutory depositor preference (ranking of creditors) either. Australia now has both.

      OBR is still there as an option. I’ve argued that it will never be used for a major bank, and that deposit insurance increases the chances that it will be politically palatable (because depositors would have paid for protection, and wholesale creditors could then be exposed to losses).


      • I thought that OBR was in place and already the answer to the need for deposit protection? Why is the matter being revisited anyway? e.g. RB handouts say [ ] “The Government also decided not to introduce deposit insurance. This was because it is difficult to price and blunts the incentives for both financial institutions and depositors to monitor and manage risks properly.”

        OBR provides for immediate resumption of basic bank transaction services, albeit with a depositors access to reduced levels of deposits (some taken off to meet the default and an arbitrary de minimus left).

        Since banks can currently put all depositors money to their own use, any “protection” of deposits will mean a cost, or foregone income, to be borne by depositors (and other creditors) or shareholders. I would think that securing depositors funds in non-interest bearing accounts (transaction accounts) would be less costly than insurance? Interest bearing accounts could be unsecured and funds used as at present. Of course banks would prefer a govt guarantee as they don’t have to finance that.


      • The previous government decided not to adopt deposit insurance (and under previous Governors the RB was firmly opposed to deposit insurance. The new govt has launched a full review of the RB legislation and part of the issue they are looking at is whether there should be some more specific depositor protection role, one aspect of which could be deposit insurance.

        OBR is a tool on the books should a bank be on the point of failing. It is one option that a MoF can choose (only the minister can decade) and as things stand at present very few people believe that OBR would be used in the event of a large bank failing, partly because “ordinary depositors” would share the same fate as large wholesale investors. And ordinary depositors have lots of votes….

        On your final para, yes among the options that could be explored would include narrow banks, in which (say) deposits were invested solely in short-dated govt bonds or balances at the Reserve Bank. I would favour open access to RB balances – just as everyone can hold bank notes, so anyone should be able to hold a (safe) RB account. Having said that, I think this is a both/and type of issue, and on its own such changes wouldn’t remove the political constraints at the point where a bank failed. Thus I do favour mandating deposit insurance, making depositors pay upfront for the protection they will demand at point of failure.


      • Thanks Michael, Agreed, under this Government, some form of protection is likely for political appearances reasons. If deposit insurance is the call, it would be nice if then banks would offer secured deposit accounts (or even better, as you suggest, open access to RB “real” money accounts) so that the insurance costs are made to only fall on holders of unsecured deposits, and investors can choose.


      • The large wholesale deposits I think are mainly to do with superannuation funds. Kiwisaver funds of around $70 billion definitely do have a substantial savings deposit component of around $30 billion. The largest percentage would come from default conservative Kiwisavers followed by the Kiwisaver balanced funds at 40% to 50% of the fund.

        Would not be fair to Super funds to not be protected by a deposit insurance scheme when individual savers are?


  5. Michael, very interesting post. Before I comment, let me first restate what I understood to be your key points
    – You see the case for deposit insurance as the least worst solution to the problem of bank runs
    – But do not agree that creating a preferred claim for depositors should also be pursued because, you argue, that the idea seems to be predicated on the argument that that deposit preference makes the deposit insurance cheaper to provide
    – The core of your opposition seems to be that you have to pay for insurance one way or another (no free lunch) so the better path is to simply price the deposit insurance at whatever its market value is and then allow the banks to figure out how to adjust to this cost
    – You are also concerned that assigning the risk of bail-in to creditors will be problematic for two reason 1) the small deposit funded banks don’t have any material layer of senior creditors to do this, 2) the tiger banks that do have senior borrowings risk alienating the foreign investors that NZ relies on

    Hopefully I have captured the key elements of your position. I am interested in your response to a couple of questions:
    1) You state that no-one thinks that the Australian government could do anything other than bail out the big banks in the event of a crisis but the recent discussion paper released by APRA indicates that they do want the big banks to issue a larger tier of loss absorbing capital that could be converted to common equity in the next crisis
    2) APRA seems to share your concern that the senior debt rating should be insulated from bail-in risk and their solution (more capital that can be converted to common equity in the event of a non-viability trigger) does seem to achieve this while still retaining deposit preference
    3) You are 100% correct that the bail-in solution does not help small banks that are mostly deposit funded but that is not its purpose – these banks can be allowed to fail (or taken over) because they are not TBTF while deposit insurance looks after their small deposit holders
    4) You did not discuss OBR directly but can you expand on how deposit insurance and OBR would interact – I also would have thought that your concerns about foreign investors stopping lending NZ applies just as much to OBR as it does to a bail-in regime so does this mean that OBR can never be used in practice?

    To be clear, none of the questions above challenge your argument that reducing the cost of deposit insurance is not a good rationale for depositor preference. I just feel that depositor preference is desirable on its own terms
    – in part because bank deposits function as money so their value should be insulated from risk as far as possible (I am not a fan of OBR for this reason plus the fact that depositors are not well equipped to play a market discipline role)
    – but also because it seems useful from a market discipline perspective to have a pool of loss absorbing capital pre-positioned on the balance sheets of the big banks as a way of pricing and controlling the TBTF problem.



    • Thanks for your comments.

      On your framing of my position, my support for deposit insurance is not to deal with runs, but to help deal with the political imperative that will otherwise lead to political bailouts of (big) banks. If we are going to end up protecting people, I’d rather charge them an insurance premium up front (as with, say, earthquake or accident insurance, at least in the NZ context). I also think that separating the interests of depositors from those of other creditors (through deposit insurance) increases the chances that OBR will be allowed (by politicians) to work, and that other senior creditors – many offshore in the NZ context – will be allowed to lose money in the event of failure. If depositors are in the same boat as other senior creditors, the easy default option will be bailout of the entire bank (in practice, Australian political pressure is likely to push NZ govts to agree some sort of joint bailout of the big Aussie banks anyway).

      I generally favour ex ante deposit insurance, and one thing I’m not clear on is how the premia would be likely to work in the presence of statutory depositor preference. The chances of retail depositors with a big bank (with lots of wholesale funding) ever losing money would be exceedingly small, but if that was reflected in the deposit insurance premia the wails would be heard, without ceasing, from the small local banks, and it would be interesting to see if the political process was able to resist a (false) harmonisation.

      On the foreign wholesale funding, there has always been some unease about the potential implications for ongoing offshore funding for other banks if creditors of one bank were allowed to lose their money. I’m probably a little more optimistic on that score than I was 10 years ago, but it is impossible to tell in advance and that uncertainty will weigh with politicians considering how to handle a future crisis. But my point re depositor preference was that whatever the risks around foreign funding, they will be exaggerated – as a crisis approaches – if we move to statutory depositor preference. If there were to be a 5% overall deficiency of assets (to meet all creditor claims) that is one thing if evenly spread across all creditors, but quite another if it is 0% loss for depositors and a 25% loss of other creditors. Such creditors would look to have the incentive to run – or not rollover, or sell on the secondary market to the extent it exists – earlier/harder. That is offset by a reduced retail incentive to run, but there is no obvious overall costless gain.

      On your final points, I’m more sceptical of the ‘money’ argument for depositor preference (why is my $100000 term deposit conceptually different than say a $1m bank RCD held by my superannuation fund?) but I’ve been having this debate with another reader and might try to come back to the point in another post.


      • Michael
        First up apologies in advance if I have misunderstood or misrepresented your position in the response below.

        I think we agree that the NZ (and Australian) banking system’s high reliance on senior funding means that this form of funding should be well insulated from risk. The main point of difference seems to be that I believe that deposits should be largely information insensitive (to use Garry Gorton’s term) if they are to function as money and see deposit preference (plus deposit insurance) as a way to achieve this outcome.

        In response to the money argument for deposit preference you have asked what difference is there between a $100,000 term deposit held in your one name and a $1m RCD held by your superfund. Is the distinction that matters the size of the deposit or the holder? I am not familiar with the detail of NZ’s system so it would be helpful if you explained why the difference matters. I can see that the smaller balance is more likely to be covered by deposit insurance (which I assume is mostly a political choice) but how does the distinction between personal and superfund impact deposit preference?


  6. I still think that it is a better idea for the government to make government treasuries and bonds much more broadly available, well publicised & in retail lot sizes as “term deposits”. I know these are available to some degree now but it is not widely understood by the public.

    These could be sold via commercial banks with the banks taking a very small % as admin fee or the government could do it all online.

    The public would then understands via an education campaign that the government term deposits are as “risk free” an investment that one can get & that commercial bank deposits carry a degree of risk.

    Commercial banks would continue to offer their own term deposits which would have higher interest rates & no deposit insurance & be subject to a haircut if a bank fails. This would however not stop government from legislating for depositors to rank ahead of creditors.

    Should commercial banks wish to do so they could offer deposit insurance if they are able to, under their own volition find reinsurance.

    This approach would avoid the deadweight costs of having to establish and administer a deposit insurance scheme.


    • I doubt commercial insurance, voluntary or mandatory, is a feasible option for systemic risks, partly because of the correlation of shocks/crises across the world (unlike say earthquakes). I favour opening up deposit a/cs at the RB for ordinary citizens, but it won’t stop the pressures to “do something” at the point a big bank fails.


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