Not tenable in a crisis

On a quick read through the Executive Summary of the latest consultation document from the review of the Reserve Bank Act, there look to have been a range of not-entirely-unreasonable in-principle decisions made by the Minister of Finance.   Some even look thoroughly welcome, if long overdue, including the in-principle decision to end the charade that the Board of the Reserve Bank could or would adequately do the job of holding the Governor to account.  In turn, the decision to stop the Governor being the sole decisionmaker on banking regulatory policy can’t be implemented soon enough.

The other major change that I welcome, and have championed for some years inside and outside the Reserve Bank, is the decision to introduce a deposit insurance system.   Among advanced countries, New Zealand has been increasingly unusual in not having such a system.  The discussion of deposit insurance issues is from page 85 onwards in this document.

There are lots of details still to be sorted out, but the headline-grabber in the announcement yesterday was the aspect of what is proposed that I have most problem with.

The Minister has also made an in-principle decision that the scheme will protect eligible depositors’ savings up to an insured limit, proposed to be in the range of $30,000-$50,000 per depositor.

This has the feel of a bureaucratic compromise, including with the staff at the Reserve Bank who have consistently opposed deposit insurance.    More importantly, it is a ridiculously low limit which would almost certainly prove untenable, unsustainable, in an actual crisis.  David Tripe, at Massey University, calls it “a joke”, but it is (of course) more serious than that.

I favour deposit insurance mostly for second-best reasons.   You can advance various arguments for why deposits should, in principle, be specially favoured and protected.  I’m not really convinced by any of them.  If people really wanted rock-solid assets, and were willing to pay for them, the market could and would provide.  The evidence is, quite strongly, that people don’t (look, for example, at the tiny number of people holding government retail Kiwi Bonds, in contrast to the amount in bank term deposits etc).  And that isn’t surprising. Not only are banking crises rare, in countries where markets are allowed to work –  how much different the literature and mindset in this area might be if for 150 years Canada had had US banking etc laws, and the US had had Canadian ones –  but in the course of our lives many of us are much more likely to have serious  –  larger –  unexpected losses (financial or otherwise) from other sources.  A leaky home, a lost job, a serious relationship break-up, health problems, a business plan that just didn’t work out, an unexpected change in government policy,  living in a town that economic activity moved away from, and so on.

I’m not even persuaded by arguments about bank runs, that seem to have appealed to the authors of the consultation document (and the IMF and OECD).  There is little evidence of irrational runs and –  as we saw globally in 2008/09 –  wholesale creditors are at least as capable of running for their money, rationally or otherwise, as small depositors.

No, I support a credible deposit insurance system because governments –  abroad, and here –  have a demonstrated track record of bailing out depositors, and whole banks, when faced with a crisis, and political incentives that mean it would be difficult to change that track record –  perhaps especially in a political system such as our own, where so much power is bested in the executive, and the executive governs by commanding a majority (at least on supply issues) of Parliament.    If we believe in the importance of market discipline (beyond simply shareholders) – and I do –  then we need to do what we can to identify and recognise the pressure points and to internalise the costs of the protection they result in.   In this case, it is a concentration of (likely) voters, facing (potentially) large and visible immediate losses.

I’ve run through the likely political calculus in earlier posts (eg here), but suffice to say that I just do not believe that a plausible New Zealand government, faced with a plausible failure scenario for a major New Zealand bank, would let a bank fail, and use the OBR tool on all creditors, with protection only (via a deposit insurance scheme) for $30000 to $50000 per depositor.

The government has sought to argue that the proposed cap on coverage is somehow internationally mainstream, but I don’t know who they are trying to fool (themselves apart?).   This chart is from the official document.

dep insurance

You can ignore the strained attempt to split OECD countries into two separate classes and just focus on the data.  Whether you look at the limit in simple dollar terms, or as a ratio to GDP per capita, the range of coverage the government proposes here would be lower than in all but two OECD countries.   And perhaps the thing that stands out to me most starkly from the chart is how many of those red dots (the other country limits in NZD terms) are at or near $150000.

Not unimportantly, the limit in Australia is A$250000 (just a bit more than that in NZD terms).  The government has probably noticed that the big banks in New Zealand are all subsidiaries of Australian banks.  It is probably aware that if a big New Zealand bank ever gets to the point of failure, it is highly likely to be a situation in which the parent is also on the brink of failure.  And anyone who has ever thought about the issue recognises the high likelihood that the resolution of a failed Australian banking group, with major operations in New Zealand, is likely to be handled at a trans-Tasman political level (including because of pressure from the Australian government to keep the banking groups together, which might well be the best way to realise value for creditors).  Most likely, the big banks would simply be bailed out completely.  But if they weren’t, how credible do you suppose it is that a New Zealand government will simply walk away from depositors with amounts in excess of, say, $50000 –  left to the tender mercies of OBR –  while their Australian siblings (in a bank with the same brand) are protected to A$250000?  Not very, would be my answer.     (And bear in mind the complication that it is generally recognised that if OBR is ever used, the non haircut deposits in any failed bank will need to be government guaranteed, and that such a guarantee may even need to be extended to other banks, to avoid a big loss of funds to the failed bank.)

I’m not arguing that we need the same limit as Australia –  apart from anything else, New Zealanders are poorer on average (but would it have hurt to have looked at common model?) –  but a $30000 to $50000 limit will simply strike people as so low that it won’t be persisted with if and when a crisis hits.  Deposit insurance limits get changed on the fly –  it happened all over the advanced world in 2008/09 –  and when they are, those who get the protection won’t have paid for it.    Failing to get this right, ex ante, simply increases the risk that when the crisis comes we’ll end up bailing out wholesale creditors (including foreign ones) too.

Much better to put in place a credible limit (indexed to inflation or nominal per capita, to remain sensible) –  perhaps $150000 per depositor – and charge depositors directly for the protection the Crown is proposing to offer.  Don’t –  as the discussion document talks of –  build up a modest fund and then stop charging the levy.  Remember that major bank failures are (and are supposed to be) very rare events: a levy of 15 basis points per annum on insured deposits for 150 years, would cover losses of (say) 20 per cent of all insured deposits (an extraordinarily large loss).   But just like your house insurance, the best outcome is if you pay your premium all your life and never need to make a claim.

The consultation document discussion on deposit insurance is itself something of a mixed bag.  At a technical level, some of its seems solid enough, but then they attempt to buttress it with overwrought claims.  There was this, for example

The GFC showed that a loss of confidence in one bank can rapidly spread throughout the financial system through ‘contagion’ that causes instability and destroys financial and social capital.

“One bank”????     And, even more far-fetched

The OECD (2013) and IMF (2017) have both warned that, without depositor protection, New Zealand is particularly vulnerable to contagious bank runs that can escalate into banking crises that destroy social and financial capital. The financial costs alone could be profound and long-lasting: experience overseas suggests that in a bank crisis GDP might fall 20 percent below trend, and the Government debt-to-GDP ratio might increase by 30 percentage points for a decade.

As we have seen, in analysing the Reserve Bank’s claims around bank capital, most of those “cost of crises” analyses simply don’t withstand serious scrutiny.  But, even if they did, no serious observer would claim that the presence or absence of deposit insurance in the difference sparing us staggering GDP losses.  Here, officials and the governments are attempted to sell us a model in which financial crises arise out of nowhere, and they know –  even the Minister really should –  that that is simply not so.

But I was left wondering quite how much the Minister of Finance understands when I saw him reported as suggesting that

A bank deposit protection scheme may help defuse the battle between the Reserve Bank and the country’s biggest trading banks over how much extra capital they should have to hold on their balance sheets, Finance Minister Grant Robertson indicated today.

It is a lot more likely to amp up the tensions I’d have thought.  From a fiscal perspective –  the Crown as underwriter of a deposit insurance scheme –  deposit insurance increases your interest in having bank capital ratios as high as possible (and the discussion document talks of funding deposit insurance with a levy on bank profits, rather than directly on insured deposits). But it was noticeable that there was no discussion at all of the interaction between the two: in principle, the higher your minimum capital ratios, the cheaper the deposit insurance should be.  I guess we will know the Governor’s final decision on capital before the Minister tries to legislate deposit insurance, but you would hope for some more joined-up discussion at some stage.

On which note, on the Radio New Zealand news last night, I heard the Prime Minister quoted as saying (apparently at her post-Cabinet press conference)

“Our banking system is one of the strongest and most resilient in the world”

I suspect she is probably right about that (floating exchange rate, vanilla loan books, little or no government interference in housing finance markets, no history of recent financial crises, banks part of much bigger overseas groups (from a similarly governed country).

But, if she is right, if that is what she has picked up from her briefings, from Grant Robertson, and perhaps even from the Governor, what possible grounds are there for requiring the huge increases in minimum bank capital ratios that the Governor is currently proposing?  We’ve not seen a cost-benefit analysis (but, who knows, perhaps she has).  On the face of it, let alone digging more deeply, there is no such case.   She is content, it appears, to let an unelected bureaucrat impose potentially large costs on the New Zealand economy  –  over a period (next few years) when things are likely to be difficult anyway –  for little or no gain (given the strength and resilience of the banking system, of which she spoke, and the inability to commit to such capital standards for more than a few years ahead).

 

 

18 thoughts on “Not tenable in a crisis

  1. I suggested to Grant back in early 2017 that we needed to have a more systematic deposit insurance scheme here and that it should be initially backstopped by the government but ultimately self-funded by the banks with an agency such as Guardians or ACC managing the funds which would build up over time via a levy. I think this is far more sensible than the ridiculous approach we currently have so this is a good step forward. The amount is too low though, needs to be something like $100k or even $250k.

    But it’s a start

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  2. Grant may not be implementing the changes exactly how we’d like them Michael, but it’s far better than the previous Administration who buried their heads in the sand.

    The previous administration of both the Government and the Bank were blind to any views they didn’t already have. The world is awash in competitive ideas and the Bank should have welcomed engagement with people who disagree with them. Instead, crickets…

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    • A bit of a mix I”d have thought. After all, GW did try to convince the previous govt to change RB governance (not to a good model, but…) and Steven Joyce did commission Iain Rennie to write a report which recommended more serious reform. And the Nats were scarred by inheriting the problems of the DGS.

      But, yes, the current review process is actually doing some good stuff. Not sure I’d be a generous as (you could be read as) to suggest the Bank is now more open to competitive ideas, but…maybe. (And wonders never cease: I actually had a written apology from them this morning on something)

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  3. Thanks Michael appreciate your analysis.

    I look at the issue like this:

    1) At the last GFC the Government ‘guaranteed ‘ deposits of up to $1million. On the basis that past behaviour is the best indicator of future behaviour – I would argue that this level of support is currently factored into the market.

    It is effectively a subsidy from the govt to the banks and depositors although an operating banking system is also a public good.

    2) For this reason I am supportive of an explicit guarantee scheme – with levies – so that the people who are getting the benefit contribute to the cost.

    3) However a low explicit scheme has now said to people with deposits over the threshold they are on their own. The govt has turned its mind to the level of risk it will accept and will insure accordingly.

    4) It might do something more in a crisis – as Cullen did previously – but I see this as coming from a different place where no one believed the ‘everyone is on their own’ framework. Now if they bail out everyone there will be an angry group – under $70k – who had actually paid for their guarantee and see the rich people getting a free ride. So I see this politically as less likely to happen than before.

    5) For this reason I see the risk on such deposits as having gone up substantially. Returns are currently not high and there is no a risk in a crisis of loosing money completely. This can be compared with shares or housing where markets fall but have a chance of recovering. There is no chance of recovering funds at all here.

    6) Therefore I see the rational thing for investors over $70k to move their money to shares and housing. In practice – knowing NZ – that will be rental properties. With consequent upward pressure on house prices.

    Interested in your perspective on this.

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    • Thanks Andrea. On your last three points:

      Re 4), it might depend how the dep insurance is funded. if done by a levy on bank profits, it won’t be so visible to the people with deposits less than the cap (and the incidence may not even fall on them). But would there even be a strong pushback? I’m more sceptical of that, partly based on the overseas experience in 08/09 when the dep insurance caps were suddenly increased everywhere. And the most likely response here to a major bank failure still remains a total (trans-Tasman) bailout. All these schemes – OBR and dep insurance – are much more relevant, in my view, for dealing with the failure of a small local bank (or deposit-taker: the consultation proposes a single regime for all deposit-takers in future, which is a step in the right direction).

      On 5, I wouldn’t overstate things. The chances of losing money completely in a bank failure are not high. It is a few years ago now, but I recall commenting on a paper (I think by a Tsy staffer) reviewing literature suggesting that in retail bank failures losses of 20% would count as large. Easy to lose that much on a house or shares, and perhaps with a higher probability?

      On 6, I’d be surprised if there was a material change in behaviour. If the govt goes ahead with dep insurance as planned, I don’t think it will be v credible, and i think there will be much the same uncertainty there is now (including because of the political pressure around any Aus bank failure). More generally, even if there were such a change in preferences, freeing up land supply would prevent any sustained additional upward pressure on house prices (stuck record I know, but still….)

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    • First thing behaviour wise is people with a lot of cash will open an account with every available bank and spread their cash around. This government, in the event of a call on the guarantee, would probably cheapskate it by limiting the guarantee to all accounts with balances under or equal to the cap on the guarantee

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      • of course, (a) diversification is wise, and (b) in a crisis not every bank fails, and certainly not at the same time. Nonetheless, hard cases arise where immediate diversification isn’t that feasible (eg just got receipts of a house sale, and waiting to settle on a new purchase in a few days’ time). These are the sorts of cases that lead some people to conclude that money-like assets should be treated differently, and should be fully protected. I’m not really persuaded myself (various reasons that I might make the subject of another post), but that argument is one reason I favour the RB being forced to offer electronic deposit accounts to retail depositors (the risk-free option would be available, at a – modest – cost, and my prediction is that very few people would use it).

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      • RBNZ (or some government agency) providing digital electronic only accounts is a no-brainer. Wonder why we get swamped by intellectual noise about banking issues but nothing done about such a simple solution. Must be too simple.

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      • The Rb has been opposed – they argue it would destabilise the financial system (altho I haven’t yet read their new paper, from last week, about the future of physical cash). Another topic for a post, some day.

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  4. I think most people agree the Government would step in and support depositors if that looked politically needed in a bank failure or crisis – all past experience demonstrates that. Any traditional form of management of that involves a cost – to someone

    Thinking people must abhor the apocalyptic language of crisis and failure that accompanies any comments on bank risk these days. As you and others have noted our banking system is sound by international standards and talk of failure or higher capita ratios unjustified.

    The rhetoric is being used to protect regulators from any possible accountability and make their lives easier, at a cost to customers and taxpayers who should evaluate the potential losses and gains for themselves. Risk is a probability of gain or loss – not just exclusively loss.

    But the political reality has made the crisis – So why not just eliminate the risk?

    Where I see an opportunity lost is in making the payment transaction system risk free (and thus cheaper and simpler) – the payment system is as fundamental and important a utility for us as energy and roads.

    Interbank payments are already made riskless for banks by using sovereign money in the ESAS, already improved by adding the SBI interface. Daily settlements are around $30B with approx. $4B being retail transactions.

    Narrow money is $6B notes and coin. Transaction deposits $66B.

    First step – make transaction deposits of Banks a sub account of their ESAS accounts – thus sovereign money.
    Second step – make depositors owners of their own deposits (like notes and coin).

    Voilà!

    * Transactions deposits are fully protected;
    * Bank money based savings and term deposit accounts and credit based transactions can continue as now;
    * Banks have improved capital ratios (less liabilities) – customers and shareholders benefit;
    * Government and regulators show leadership and sleep easy with no depositor loss risk;
    * No Government or customer costs; and
    * Payment systems can be simplified and costs reduced.

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  5. The proposed limit is a joke.
    NZer’s can fully insure a house etc, but not hard earned savings.
    Its yet another bias against saving in the economy as well as the taxation rate vs other savings vehicles.
    Also in terms of creating a level playing field and trans-tasman market the limit should be the same as Australia in local currency at 250,000NZD.
    If the government’s not willing to go down that path then it should make NZ bonds widely available as “risk free” available as term deposits through the commercial banks, with the banks taking an admin fee, say 0.01%, and bank term deposits remain unsecured,

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  6. “If people really wanted rock-solid assets, and were willing to pay for them, the market could and would provide. The evidence is, quite strongly, that people don’t (look, for example, at the tiny number of people holding government retail Kiwi Bonds, in contrast to the amount in bank term deposits etc).”
    I agree. But that is mainly because a large proportion of the population (including even educated, wealthy people) believe the govt insures all deposits. (A significant proportion also believe KiwiSaver accounts are govt protected.)
    I have mentioned the OBR this week and the fact bank deposits aren’t guaranteed to a wealthy businesswoman and another top-end real estate agent and both were astonished to learn they aren’t.
    I guess when we talk about improving financial literacy, no one wants to point out there is no guaranteed backstop for your savings at present.

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      • To be fair, the government does not actually borrow very much(note the lack of infrastructure spending and lack of social housing and as a result there is not too much available Kiwi bonds to invest in. Most investment funds including Kiwisaver when you specify a Balanced Investment fund equates to at least 40% of the fund would be invested in Term deposit savings accounts. So you actually can’t get away from investing a lot into Term deposit savings.

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  7. I can solve a bit of your surprise. the EU rules dictate deposit insurance up to €100k (more like NZD170k than the 150k shown herenowadays). That accounts for the clustering of so many countries at that level in the chart.

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