Political equilibrium, OBR, and deposit insurance
There has been some discussion of deposit insurance, the open bank resolution plan, and the types of risks being faced by New Zealand savers. This is actually a hugely important issue, and as a broad matter of principle I actually find myself agreeing more with Labour and the Greens than National and the Reserve Bank. My view is that deposit insurance should be announced, it should be explicit, there should be certainty around it, and it should be treated as a form of “compulsory insurance” with the payment of an associated “insurance levy on debt financing” for financial institutions over a certain size. Of course, even with this the OBR still has a place (it is actually a very separate issue) – and that is why the RBNZ was right in saying this.
In order to see why this is the conclusion I’ve drawn, one that differs from current policy, let’s have a brief look at my thought process through a post.
Political equilibrium, credibility, and expectations
Bailouts are a topic that the government, Treasury, and the RBNZ are justifiably wanting to avoid talking about too much in public. Why this is justifiable, but the reason why we may need to be more transparent about it, comes from thinking about the expectations of people both within and outside of a bank run.
Governments and central banks are perceived by people in the economy to be the lender of last resort – due to a view on bank runs. Having a functioning lender of last resort means that, in the worst case scenario, these institutions will act as a lender of last resort. In this way, the NZ government is expected to bail out large financial institutions (in the NZ case banks) if they fail.
Now on the face of it we might not like this. We don’t bail out other large companies. And with an implicit backstop, financial institutions will take on too much risk (and the people funding these institutions will assume there is far less risk) – this is the problem of moral hazard. In this way, the expectation of a bailout creates a difference between the “full social riskiness” associated with lending and the risk that private individuals and firms face when deciding to lend and borrow between each other, through a bank.
The Treasury, government, and RBNZ acknowledge this moral hazard issue – and so they want to introduce the open bank resolution policy settings as a way of avoiding bank runs (which is why we have deposit insurance in the first place), insuring the bankruptcy is orderly for financial institutions (to make the costs to everyone involved, from negotiating about who gets what, as small as possible), and limiting the number of situations where “bailouts” will really be required.
This is good, this is exactly what they should do. However, the scheme lacks three things when it comes to thinking about “expectations”:
- Clarity about how losses are determined and split in a typical situation that requires bankruptcy – an issue that will be solved soon.
- Clarity around how this links to the lender of last resort function of the central bank.
- The political incentives to bailout banks.
Let us be honest here. The government will not let a bank fail. They will not let depositors lose money. It is in the government’s interest during a bank failure to have taxpayers pick up the tab. People know that the government will do this (or at least form expectations based on this) as so will lend to banks in a way where they are seen as riskless! There is an implicit deposit guarantee scheme for banks at the moment! This is the key point – even if we aren’t admitting it, there is a deposit guarantee running at present that we aren’t acknowledging.
As a result, it makes sense to turn around and make this explicit. Note: If the government thinks it can costlessly credibly commit to not bailing out institutions, and the RBNZ can solve the issue of bank runs without full deposit insurance, then this is good. But we do not have that right now, not in the slightest, and it should be admitted as policy relevant.
This doesn’t seem particularly fair on the taxpayers
No it doesn’t. According to most free instant cash advance apps, the tax payer is essentially subsidising loans. The subsidy is then split between depositors, the banks, and the borrow due to relative elasticities, information, and bargaining positions. Overall “too much” is invested due to what is socially optimal … this is where we have the “too much debt” business.
If we make the deposit guarantee explicit instead of implicit and we completely remove the loss from default – if anything it will exacerbate the moral hazard issue issue! So what do we do?
Deposit guarantees are a form of insurance. Generally, you pay for insurance with an insurance levy. If we have an explicit guarantee scheme on deposits, then there should be a levy on those deposits.
Yes this will reduce investment, yes this will see lower returns to depositors, but without doing this we have a deposit guarantee scheme that just costs everyone in NZ and in turn makes the entire financial system more unstable.
The kicker with all this is that the insurance scheme will have to be compulsory for all institutions over some type of nominal size. The type of bank failure we are concerned about, and which will lead to bail outs, stems from an episode where there is systemic risk to the banking sector as a whole. In that case the incentive to take on the insurance for an individual firm does not match the full social return associated with it. Furthermore, if the bank decides to take on insurance it may be seen as a signal of weakness (given asymmetric information) making banks unwilling to take on the insurance for signaling reasons. Finally, the political eqm argument suggests that a government may well bail out the bank irrespective of whether they have taken on the insurance – making a bank unwilling to pay for insurance they can expect to get anyway.
Conclusion
At the moment there are two ways forward when thinking about banking policy in NZ:
- Explicit deposit insurance, with an associated deposit levy.
- A credible commitment by government that it won’t guarantee deposits combined with RBNZ regulation that can avoid bank runs.
Current policy is trying to push towards the second (which is admirable), but in the current environment I do not believe it is credible given the idea of “political incentives”. Which is why I find the idea of explicit deposit insurance combined with a deposit levy to be the best way forward.
Note: Concern about levies is a fair point. If we are the only country “not subsidising”, what does that mean for us? I’d note that the big runs here come from trying to introduce this during a crisis – it doesn’t rule out the effectiveness of the policy outside of a crisis. In a number of ways this would be similar to the FDIC – just with appropriate insurance premiums (which are ex-ante pretty danged hard to determine), and with an appropriate scale to ensure that the government can commit to no more additional bailouts.
Note 2: Good post by Eric stating why he thinks the government can commit.
RBNZ cannot bind future governments. But setting up the regime well in advance of a bank failure specifying that, no matter what else happens, the equity and (subordinated) bond holders get burned first gives those agents reasonable expectation that they should try to make sure that doesn’t happen. If some future government defects by bailing out depositors, I’d expect it to happen only after burning through the equity and bondholders.
Note 3: The Economist points out research by the IMF that shows explicit deposit insurance makes the moral hazard problem more acute – this is a pretty easy to understand idea, and we mentioned the concept above (just under our second subtitle). This is why we both require a levy, and have to accept that it is “inefficient” relative to a situation where the government commits to not bailing out banks AND we have a way to prevent bank runs (where by this I mean optimally reduce the probability of a bank run so the expected cost of it happening is equal to the expected cost of introducing preventative measures). If we can do that second bit – then do it, and scrap the compulsory insurance.
If I were to make an argument for deposit insurance, it would be the one you’re here making.
Here’s the argument I’d make against it.
The current policy helps build credibility around a no-bailouts solution. First, they only haircut depositors after they’ve liquidated the bank’s shareholders and creditors. Or at least that’s how I understand things work. Part of depositors’ accounts are frozen while they figure out what assets the bank still has; in the end, depositors only take a haircut based on what fraction of depositor’s claims can be backed by bank assets. Correct me if I’m wrong on this though. So they liquidate the bondholders, liquidate the shareholders, then see what the excess of deposit claims over assets is. The haircut would not be likely to wind up being all that large, though the initial freeze could be a bit larger.
SCF and the rest were a mess because nobody had a set disaster plan; they had to make stuff up in the middle of an election when everything was looking pretty scary.
Now look at what the government has done on bailouts in Christchurch post earthquake. There was tremendous pressure to extend coverage to those who hadn’t purchased insurance; the government said no. If anything, you could say that the government is imposing large takings on owners of bare property in the Red Zone where it was really not obvious that it was ex ante possible to buy insurance. They’re getting offers for what, half of the ex ante value? And with a gun to their heads that they’ll have compulsory acquisition at worse terms, or be denied any city services to the property, if they refuse the offer? Maybe some other government would be less willing to tell people to get stuffed. But this one’s seemed pretty willing despite all kinds of very public stories of severe hardship consequently imposed.
My rejoinder to that argument would then be that we’d expect in a banking crisis that the banking execs would get the hooples very excited about the prospect of losing 50% of their deposits rather than 10% and then use that to twist arms to get a bailout to prevent bondholder and shareholder liquidation.
I’m not sure what state of the world is more likely.
I saw a great tweet yesterday. Said “I’m actually pro-bailout. I just want the bank’s executives and board members shot in the face as part of the process.” Can we do that with deposit insurance too?
Yar, I agree – if we think we can build credibility, along with some sort of scheme that clearly involves forcing bondholders to become equity holders in some restructuring, then I can see it being preferable to blanket insurance. AND I think this is where the RBNZ and Treasury are going with this.
I feel like we need more clarity about things before credibility can be established. And this is where I think the debate needs to be. Having a situation where credibility is not established so we have implicit insurance with no levy imposed seems like a bad place to be.
Matt, even though I am not an economist and do not fully understand some of the issues you raise, I enjoy reading your column. It is thought provoking.
My wider reading informs me that it is the retail banks, rather than central government, that create much of the new money entering our society. And that central banks no longer have effective means by which to regulate/limit the money supplied by banks. People with access to the new money naturally (driven by greed/envy) want to spend it and it is this that has led to the GFC.
I am sure it is not that simple. But my point is that an open bank resolution plan and/or deposit insurance scheme is akin to an ambulance at the bottom of the cliff – why is our government not moving to regulate banks (as they used to be 60(?) years ago) to limit their ability to create new money and so avoid the need for the expense of an ambulance?
Cheers.
“My wider reading informs me that it is the retail banks, rather than
central government, that create much of the new money entering our
society. And that central banks no longer have effective means by which
to regulate/limit the money supplied by banks. People with access to
the new money naturally (driven by greed/envy) want to spend it and it
is this that has led to the GFC.”
The central bank provides intra-day liquidity at the OCR, so that retail banks can meet investment demand at the interest rate implied by the OCR and rates markets. Money is “created” in a way that is pegged to the inflation target, and underlying demand for investment.
Banks in this case are an intermediary, and we have to look at how they function to figure out what is going on. Calls to “greed” or “too much money” aren’t a full description of what is going on.
“I am sure it is not that simple. But my point is that an open bank
resolution plan and/or deposit insurance scheme is akin to an ambulance
at the bottom of the cliff ”
This is a fair point. The idea is that if depositors realise that there is risk, they will incorporate that in the rate of return they demand from banks – as a result, when banks go to loan they will recognise that borrowing is more expensive than it was previously. In this case, they will lend out less, and use proportionally more equity funding.
Now note that the central bank provides intra-day lending facilities – but the retail bank needs to match assets and liabilities … it can’t just sit there borrowing off the Reserve Bank forever. As a result, the cost of credit on this side matters as well.
So by doing this, the RBNZ gets banks to take into account the risk of default more when they are loaning out – and that is why the OBR makes sense. I like it as a principle, but I am not sure whether a government would let a bank fail, and so I fear that there is a big hole in this when it comes to thinking about what will happen.
Perhaps a no bailout clause would be a good candidate for inclusion in any NZ constitution. The RBNZ should have a chat to the working group. Requiring 75% support to change the constitution before a bank can be bailed out would help to increase credibility.
This is very true.
Of course there is the elephant in the room. What happens if NZer’s have a social preference towards protecting depositors? If that is the case, and that is why people are so annoyed about the idea right now, then the OBR is really something that is against what society wants relative to an explicit guarantee with an insurance premium.
This is an issue where the trade-offs need to be made clear, and then we really need a democratic decision. Ultimately, people do believe that society should provide a risk free asset that people know about – I will post on this at some point methinks.
My take on OBR is that it is intended to resolve small bank failure at little or no cost to the taxpayer.
The reality is that the Aussie banks are “too big to fail”. Westpac, ASB, BNZ and ANZ each make up around 20% of the market – I can’t conceive of a situation where one of them falls over and it not resulting in a run on the other three. The government would not be willing to let 80% of the banking sector ‘resolve’ using OBR – they would be forced to bail out.
Kiwibank is an SOE and on this basis already has an implicit state guarantee. A Labour government would bail them out and Bill English would take great pleasure in selling them if they got into trouble.
But there is a third tier of small NZ owned banks (SBS, TSB, Coop and Heartland). They have poorer credit ratings than the big four and also have a customer bases with a strong regional (TSB,SBS) or industry (Heartland) bias which might make them vulnerable to shocks in their particular market.
Each of them has at least a couple of billion in deposits and are all growing fairly fast. Any one of them falling over in the next few years would blow a hole in the government accounts that would make South Canterbury Finance look like a walk in the park.
As I see it the purpose of OBR is to allow the small NZ owned banks to fail and be ‘resolved’ (get sold to the Aussie giants) at no direct cost to the taxpayers. The sale of AMI to IAG is the kind of approach they are after – NZ owned insurer with a strong local Chch bias goes under and is handed off to Aussie company without cost to the NZ taxpayer.The four big banks will continue to have their implicit government guarantee.
I 100% agree with your interpretation, I feel the same way. I wasn’t meaning to criticise the OBR, just point out that we need to think about the implicit insurance as well. This point must not have come through correctly – so I’ve written a post to flesh it out!
Dear Matt,
In talking about OBR, deposit insurance and guarantees, it appears most people have forgotten the obvious….. secured transaction deposit accounts. Currently cheques account and deposit account funds are all treated as unsecured by banks. Some points I have been making recently are as follows:
The recent proposal to tax depositors to support a bailout of Cyprus has drawn attention to the Reserve Bank(RB)’s Open Bank Resolution (OBR) policy, due to take effect from 1 July this year. When a bank fails, OBR involves taking a “haircut” on balances in depositors accounts, to ensure continuity of operations while the bank’s finances are resolved.
As Deputy Governor Grant Spencer argues, the situations are not the same, and the RB policy makes sense – keeping banks operating when they fail so transaction flows are not stopped and there are less potential flow-on or systemic problems. RB arguments about reducing moral hazard in the bank and avoiding taxpayer funding when banks fail are also good – BUT – given the current lack of distinction between types of unsecured creditors this policy looks unnecessarily unfair to cheque (transaction) account holders, who are currently regarded as unsecured. If the OBR policy is implement this should be reviewed.
Since the effective dematerialisation of cash money, we all rely on registered banks to hold our cash in safe-keeping so we can process payments through cheques and electronic transfers. Banks cheque and EFT-POS systems are approved by the Reserve Bank and the RB is the regulator of those banks. We all use these systems and rely on the RB to ensure they operate properly and efficiently and are available when needed.
Cash or cheque accounts (transaction accounts but generally and here referred to as cheque accounts) earn typically no interest and we pay transaction fees. These monies are, and should be regarded as, different from deposit accounts which earn interest and where the bank has to put that money to use to earn more interest to pay depositors (i.e. savings or term deposits for example).
Cheque account monies should be regarded as fully secured funds and held in trust for their owners, with 100% capital protection by the bank providing security. They should not be put at risk by the bank to earn income.
In order to provide confidence and protection of the money transaction system, banks can be easily required to have sufficient funds (approved securities) on deposit with the RB at all times to ensure all cheque account monies are protected. This will cover real money (same day funds) provided by the RB to the bank to ensure all transactions of cheque account holders between banks can be completed.
Some categories of savings accounts also could be made fully secured in the same way, though these would necessarily earn less interest (dependent on what the RB pays the bank for those deposits).
Transaction operations of the bank could continue unimpeded while the financial situation of the bank was resolved and holders of secured funds would not have any haircut under the OBR. The argument for any guarantee for depositors is eliminated (since people choose to have their monies in secured or unsecured accounts), and political pressure for any taxpayer bailout of creditors is much diminished.
An interesting arguably unrelated but good moral question regarding the OBR is why not haircut or freeze bank board and executive and employee remuneration, as well as creditors/depositors funds? They are also unsecured creditors. That would certainly reduce the moral hazard risk in the bank!
Hi William,
Interesting stuff. I can’t imagine that the cheque account funds are a significant source of funding – but I do agree they are inherently different. They are purchasing a “service” off the bank for holding their funds. I should look into some data at some point for this.
The OBR is definitely about the operation of winding down a bank, rather than a direct way of dealing with the full range of moral hazard. That is a broader issue which I am trying to touch on in the post – having a deposit levy doesn’t cover moral hazard, but it does go in the right direction. It is a “second best” style of solution.
Thanks Matt,
The main reasons we dematerialize our “real” money by placing it in banks is to facilitate efficient payment transactions, or for safekeeping. The banks hold real money (same day funds issued by the RB) to cover their daily obligation to pay other banks (intraday if necessary) so I don’t see why these cheque account funds can’t easily be secured funds. Offering customers “real” accounts (same day funds) has been proposed at various times but the banks are not keen as they want the free use of those funds. They should not in my view as these funds are different.
When we give money to brokers for security transactions they are required by the regulator to hold it in trust. This is effectively in a bank account which cannot be overdrawn, cannot be used as an offset by the bank against other obligations and cannot be used without the client’s (or their broker’s) specific authority. These are effectively secured funds but I doubt they are regarded as such in the Bank’s accounts and brokers clients will not be happy if they get a haircut under OBR because the broker’s bank fails!
We are now moving to required managed funds to have trustees and custodians for holder’s assets. Why have we forgotten to secure the funds at the point of dematerialization for these transactions.? When customers choose securities or assets (including savings accounts) that put their funds at risk for return, it is only fair that the OBR haircuts their holdings in these unsecured accounts to facilitate resolution. When they haircut transaction balances which should be secured, that looks a lot like a regulatory tax.
I think the arguments for securing transaction accounts are compelling. If this is done, then under OBR any discussion of deposit insurance becomes an option for holders of unsecured accounts to choose or not as they wish. Everyone wants the government to guarantee their risky investments but there is no justification if their real money accounts in their banks are completely protected by securing them with the RB.
Yes the moral hazard issue is broader. The relevant point for OBR (not clear in their explanatory papers) is just whether ALL unsecured creditors suffer the haircut and have those funds frozen, or if there are exemptions. Do the board, executives and employees have their unpaid unsecured assets which are liabilities of the bank (wages, holiday pay, bonuses etc) subject to the haircut as well?
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