Why deposit insurance makes sense for NZ

New Zealand First could be about to win a deposit insurance scheme in this week’s coalition talks. Michael Reddell explains why deposit insurance makes sense and won’t harm the government’s finances.

New Zealand is currently the only OECD country without any sort of deposit insurance scheme. If a bank fails - and supervisory policy is designed to reduce but not eliminate that risk - depositors are, in principle, on their own. The 90-year-old grandmother with $20,000 on deposit, or the young couple who’ve been accumulating a house deposit, will suffer the same (percentage) losses as the sophisticated wholesale investor. Various political parties - notably the Greens and New Zealand First - have openly favoured introducing a deposit insurance scheme. But the Reserve Bank has been staunchly opposed. More recently there have even been suggestions that introducing a deposit insurance scheme might put a dent in the Government’s strong credit rating.

The main argument against deposit insurance is that it may weaken market disciplines. Depositors who know their money is safe won’t take as much care in evaluating the risks of the institution they are putting their money with. It is a fine argument in principle - and we’ve seen examples of that behaviour at work in New Zealand, when people flocked to put money in a guaranteed South Canterbury Finance. But when it comes to the key institutions in our financial system, everyone - even the Reserve Bank -  recognises that most of the effective market discipline comes from wholesale investors (domestic and foreign), not from retail depositors. No one wants to provide protection to those wholesale creditors.

More importantly still, the argument about market discipline assumes that the choice is between an (inevitably imperfect) deposit insurance scheme, and a situation where all depositors and creditors are equally exposed if and when things go wrong. It is the sort of story that is implicit in much of what the Reserve Bank has had to say about deposit insurance over the years. But it bears little relationship to reality. In practice, governments all too often bail out failing banks, and hardly ever let retail bank depositors lose their money.

People might wish it was otherwise, but it isn’t. Over the last decade there has been an increasing desire among regulators internationally to ensure that if a bank fails, wholesale creditors can be allowed to lose money (without undue economic disruption). There has been no such move in respect of retail depositors.

We need institutions that are robust to real-world political pressures and incentives, not ones that start from some wishful alternative world that just doesn’t exist.

In New Zealand, the Government and the Reserve Bank have established the Open Bank Resolution (OBR) tool to try to buttress the “no bailouts” message. 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 depositors and other creditors –  the size of the haircut designed to be larger than the plausible, but still unknown, actual losses.  

The OBR is an ambitious tool.  But in isolation, I’m not convinced it would ever be used for a major bank. 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 – after all there are plenty of other areas where uncompensated losses happen (eg house prices fall back, or the value of one’s labour market skills drops).  My concern is a realpolitik one. International experience, and reflection on the incentives that will face ministers in the midst of a crisis, suggest that:

- at point of failure, governments are almost certain, whatever they say now, to bail out retail depositors of major core institutions, and

*without a pre-specified deposit insurance arrangement, it is most likely that the desire to protect retail depositors will lead to the whole institution being bailed out (offshore wholesale creditors and all).

In short, there is more chance that the OBR mechanism will be allowed to work, with wholesale creditors taking losses in the event of failure, if a proper deposit insurance scheme is established.

Why do I believe that governments will bail out retail depositors? First, because they have form.

A generation ago the BNZ would have failed without a government bailout. A decade ago, the temporary deposit guarantee scheme was put in place with bipartisan support. And when AMI failed, even the Reserve Bank and Treasury recommended the subsequent bailout. People will have different views on the merits of each of those interventions. My point is simply that they happened in the past, and such things will happen again. The incentives facing New Zealand politicians are no different than those elsewhere. That is especially so when a large bank is involved -  not only are their depositors voters, but all our large banks are subsidiaries of Australian banks, and the Australian government isn’t about to let their retail depositors lose money. (In fact, in a crisis the Australian government is likely to put immense pressure on New Zealand to contribute to joint bailouts of parent and subsidiary, and it is hard to see why a New Zealand government will defy that pressure for long.)

We need institutions that are robust to real-world political pressures and incentives, not ones that start from some wishful alternative world that just doesn’t exist. A deposit insurance scheme does that. OBR is designed to allow a failed bank to quickly reopen. That is often a worthwhile goal. Deposit insurance, for retail depositors, isn’t so concerned about getting money back immediately, but about providing a base level of protection for those who’ve put their money with supervised and regulated institutions (“if the Reserve Bank couldn’t stop the failure how was the 90-year-old granny supposed to” will be the plausible cry). Set up well-understood mechanisms in advance to provide that protection to retail depositors and it is more likely that larger creditors - who we expect to monitor banks more closely - will face actual losses when banks fail. A credible prospect of losing money will heighten the effectiveness of market disciplines.

Establishing a well-structured deposit insurance scheme could well be seen, as it should be, as a refreshing dose of realism in thinking about the risk of bank failures

There are a lot of details to be worked out in establishing a deposit insurance scheme. Should it cover just banks or all deposit-taking institutions? How large should the cap be? Should there be a deductible? How should the premiums be set, and to what extent should they be differentiated by institution? Who should administer the scheme?

But the critical point for all parties to realise is that not having a deposit insurance scheme doesn’t mean that deposit won’t end up protected - perhaps completely. It just means that the people who will benefit from that insurance won’t be paying anything for it now. Taxpayers more generally will be paying. Putting a price on insurance is almost always better - and fairer and more transparent - than providing it for nothing.

And what about the Government’s credit rating? Won’t it be damaged? No, almost certainly not. Ratings agencies are realists and recognise how advanced country governments respond when banks look like failing. And at present our banks and our government accounts are in good health. That could change. But if the economy is so badly mismanaged that we run into risks of a systemic financial crisis, then whether or not there was a pre-established deposit insurance scheme is likely to be a third order concern for ratings agencies.   

In fact, it is quite plausible that ratings agencies - realists rather than idealists - could welcome a deposit insurance scheme, in the context of a strong banking system with large capital buffers and demanding minimum capital requirements. Establishing a well-structured deposit insurance scheme could well be seen, as it should be, as a refreshing dose of realism in thinking about the risk of bank failures, and as increasing the chances that if a bank does fail, governments will feel able to walk away from the wholesale creditors (domestic and foreign). In fact, only a few years ago the then-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 a deposit insurance scheme. And he didn’t appear to worry that deposit insurance might threaten the government’s credit rating.

Deposit insurance may not be a first-best solution. Reasonable people can reach different views about that. But it is a practical and prudent response to the real-world position governments are in. If they aren’t willing, or politically able, to allow retail depositors to lose money if a bank looks like failing, they are much better advised to establish and insurance scheme, to limit and charge for that insurance, than simply to pretend that the problem doesn’t exist, or to wish that we were in some alternative universe where the political pressures were different.

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