Geof Mortlock Argues New Zealand Needs Stronger Protection for Depositors to Counter the Reserve Bank’s 'Odd Approach' to Managing a Bank Failure

Monday, Feb 18 2019 02:46 PM

New Zealand currently has a strong banking system, with banks that are well capitalised and generally owned by strong parent entities. The strength of the New Zealand banking system owes much to the fact that the four largest banks (holding close to 90% of banking system assets) are owned by strong Australian banks and are overseen by a very competent banking supervision authority in Australia.

Nonetheless, no country is immune from bank failure. New Zealand is no exception. Although it is around 30 years since New Zealand experienced the failure or near-failure of banks (BNZ in 1990 and DFC in 1989), it is only a decade ago that we saw the failure of more than 50 non-bank deposit-takers; a scandalous failure of the New Zealand regulatory system that has only been partially rectified by subsequent reforms. If the global economy experiences a deep and protracted recession, and New Zealand goes with it, there is no guarantee that we will not see a bank failure or two.

In most countries around the world (and all advanced countries except New Zealand), small depositors are protected when a bank fails. That is because most countries have what is called deposit insurance – a scheme under which depositors are fully insulated from loss and guaranteed prompt access to their funds up to a specified amount if their bank fails.

New Zealand is the only advanced OECD country without deposit insurance. If a bank fails in New Zealand, there is no protection available for small depositors.  Even worse, if the Reserve Bank got its way, it would impose losses on depositors through a ‘haircut’ to your deposits to absorb losses that the bank has sustained.  Under the Reserve Bank’s approach, depositors are deliberately forced to absorb losses (after shareholders have first lost everything). In every other advanced country, small depositors are protected from losses through deposit insurance.

This crazy situation is finally under review. Thank heavens it is being led by the Treasury, given that they seem to have a genuinely open mind and mature approach to the issue.  In contrast, the Reserve Bank retains a largely irrational, ideological (almost theological) opposition to any form of depositor protection.  Its head is deep under the sand.

The Reserve Bank’s opposition to deposit insurance is based on their assertion that this would significantly weaken ‘market discipline’ on the banks and thereby reduce their incentives for prudent risk management. This is a nonsense of an argument. Market discipline on banks comes not through small (‘mum and dad’) depositors, but mainly through large (wholesale, corporate and inter-bank) deposits and other funding. These large depositors and bondholders monitor their funds in banks closely. They understand credit ratings and they understand risk. They are the ones who exert discipline on banks, both by demanding a higher price for higher risk and by, ultimately, cutting funding off from a bank if they have serious concerns about its safety. 

In contrast, small depositors – your average Jack and Jill out there – have no realistic way of knowing whether their bank is safe or how it compares in terms of risk to other banks. They can look at bank credit ratings and financial disclosures, but they do not have the knowledge or experience needed to interpret this information.  And if a small depositor did develop a concern over a bank, they would have very little scope to exert influence on the bank through the pricing of deposits, unlike large corporate depositors. Their only option is to withdraw their deposits from the bank. Moreover, small depositors, unlike the large ones, do not generally have sufficient money to spread it across several banks to diversify their risk. They tend to have most of their funds in just one bank.

In the absence of deposit insurance, small depositors are left vulnerable and exposed in a bank failure. Worse than that, the absence of deposit insurance creates a significant risk of depositors running on the banking system at the first hint of trouble. That is one of the reasons other countries have well-established depositor protection systems. The risk of a mass depositor run on banks is made much worse in New Zealand because of the Reserve Bank’s ill-conceived ‘open bank resolution’ policy, given that it involves ‘haircutting’ bank deposits and forcing depositors to take losses.

In the absence of deposit insurance, the Reserve Bank’s ‘open bank resolution’ policy is a recipe for creating panic across the banking system. It creates a risk that the failure of one bank could trigger a run on many other banks (especially in a period of financial system fragility) because depositors and other creditors would not know whether their bank is next for the Reserve Bank’s haircut. In my assessment, the risk of the Reserve Bank’s ‘open bank resolution’ policy creating a mass run on bank deposits is sufficiently high that it would likely force the government to place a blanket guarantee on bank deposits to stop the run and stabilise the banking system. In other words, the Reserve Bank’s policy – ostensibly designed to protect taxpayers by avoiding government guarantees – would very likely create an even worse risk for the taxpayer by making a blanket guarantee all the more likely.

Deposit insurance would significantly reduce this risk. It would protect small depositors by insulating them from any loss on their deposits up to a specified amount and by giving them prompt access to their deposits. This would greatly reduce the risk of depositor runs. It would also strengthen the ability of the government to enable the Reserve Bank to apply some form of ‘bail-in’ of a failing bank by imposing losses on larger deposits and bonds (after shareholders first absorb losses). Deposit insurance would avoid the need for an emergency ad hoc response from the government in a bank failure situation, such as a blanket guarantee. It would provide for a much calmer and more structured approach to resolving failing banks. And at lower taxpayer risk.

What would a sensible deposit insurance structure be for New Zealand? I think it would have the following features:

 - The deposit insurance scheme would be established by legislation, setting out the objectives of the scheme – essentially to provide protection to depositors in a bank failure situation up to a defined amount.

 - The scheme would be mandatory for all banks; there would be no scope to opt out.

 - Non-bank deposit-takers (NBDTs) licensed by the Reserve Bank should be brought within the scheme, but on the basis that they become subject to a supervision regime the same as for banks (i.e. no longer being supervised by trustees).

 - The scheme would apply to any depositor of a bank or NBDT, regardless of whether they are resident or non-resident, natural persons or legal entities, but would not apply to inter-bank deposits.

 - The scheme could be applied to deposits in any currency, but subject to a standard NZD maximum cap.  However, the simplest option would be to limit the scheme to just NZD deposits.

 - The scheme would limit the amount of protection to a specified sum set either in statute or regulation, which could be increased over time in line with inflation or the growth in the nominal average value of deposits. The deposit insurance limit should be set at a level that fully protects the vast majority of householders’ deposits so as to minimise the risk of retail depositor runs, but not so high as to protect wholesale depositors (i.e. those who can be expected to protect themselves). Internationally, the deposit insurance limit varies considerably from country to country. The international average is around US$75,000 per depositor per bank. In Australia it is A$250,000 per depositor per bank. In the EU it is €100,000. In the UK it is £85,000. In Canada it is C$100,000.  And in the US it is US$250,000. For New Zealand, I would favour a deposit insurance limit of not less than NZ$50,000 per depositor per bank and not more than NZ$100,000 per depositor per bank. The latter would be closer to international norms for OECD countries.

 - The scheme would apply the deposit insurance limit on a per person per bank basis. Under this arrangement, a person’s deposit accounts in a bank would be aggregated to a single total balance. If they have a joint account with their partner, half of the joint account deposit balance would be included in that person’s aggregate deposit balance.

 - The deposit insurance scheme would require the scheme administrator to pay the insured deposit amount to the depositor within a specified period following the closure of the failed bank.  Internationally, the standard is to complete this payment within 20 days, but increasingly deposit insurance agencies are moving to complete payments within seven days. 

 - The scheme would sensibly be structured to enable the deposit insurance fund to finance the transfer of eligible deposit balances to another bank (a so-called ‘purchase and assumption’ form of bank resolution), so that the depositor can access their deposits with minimal interruption – i.e. the deposit account in the failed bank simply becomes a deposit account in another bank, with the same terms and conditions. This is how over 90% of bank failures in the United States are handled. Typically, in the US, the failed bank is closed on a Friday. The insured deposit accounts are transferred to another (healthy) bank over the weekend. The depositor can then access their deposits at the new bank on the Monday. No loss. No fuss. No instability.

 - If the Reserve Bank’s ‘open bank resolution’ approach was applied to a failed bank, the ‘haircut’ to deposits and other liabilities would only apply to deposits above the aggregate value covered by the scheme. For example, if the deposit insurance limit is $100,000, then the haircut would apply only to deposit balances (aggregated on a single depositor basis) above $100,000.

 - The scheme would be administered by a government agency.  Rather than establish a new agency solely for the purpose, one option would be for the Reserve Bank to administer it, given that it is the bank supervisory and resolution authority. However, my favoured approach would be to split the supervision and resolution functions from the Reserve Bank to a new Prudential Regulation Authority and for that authority to administer the deposit insurance scheme. I would rather see the creation of a professional supervisory and resolution authority, separate from the Reserve Bank, rather than continue to have the Reserve Bank do the job in what, all too often, is an unprofessional manner. This would also avoid the current excessive concentration of power in the Reserve Bank. And it would avoid the conflicts of interest that exist with the Reserve Bank as supervision authority – e.g. using prudential regulation for monetary policy and macro-financial stability purposes.

 - The deposit insurance scheme would be funded by regular levies on banks and NBDTs. These would be used to build the deposit insurance fund to a level considered sufficient to meet the expected value of payouts over the long term. In the advanced OECD countries, the target size of a deposit insurance fund is generally between around 1% to 2% of insured deposits. A start-up fund would normally be given around seven to 10 years to reach the target size.

 - The bank levies would be based on their holding of insured deposits and calculated as a percentage fee per deposit per annum. Banks would doubtless pass most or all of this cost on to their depositors. And that is fair enough. No insurance scheme is free. If depositors want the benefit of safety, they should be prepared to pay for it. Typically, in most countries with deposit insurance schemes, the levy is small – usually between 0.02% to 0.05% per annum. On this basis, an insured deposit interest rate for one year might fall from around 3.5% currently to maybe 3.45% under a deposit insurance scheme if the bank in question passed on the full deposit insurance levy to the depositor.

 - A risk-based bank levy could be established. This is done in some countries. And sensibly so in my assessment. It means that higher-risk banks and NBDTs (e.g. those with lower capital ratios, higher risk appetites and less diversified portfolios of assets) pay a higher deposit insurance levy than banks and NBDTs of lower risk (e.g. banks with higher capital ratios, strong asset quality, conservative risk appetite, etc). This would help to strengthen discipline on banks and NBDTs and reinforce incentives for sound risk management.

 - The deposit insurance scheme would need to have either the ability to borrow from the government or from the financial markets (with a government guarantee) in situations where it did not have sufficient funds to make payments. It would then repay the full amount of the borrowing (including interest) over time through higher levies on banks and NBDTs. This is a conventional feature of deposit insurance schemes in other countries.

 - Finally, the scheme would be enabled to use its funds to contribute to the funding of alternative forms of bank resolution, subject to it not paying more than it would have done under the lowest-cost form of deposit payout.        

The sooner New Zealand establishes a deposit insurance scheme the better it will be for the millions of New Zealanders currently exposed to the whims of the Reserve Bank’s odd approach to managing a bank failure. And the sooner we will have a financial system in which small depositors can feel that their funds are safe.

*This article was published here: https://www.interest.co.nz/opinion/97926/geof-mortlock-argues-new-zealand-needs-stronger-protection-depositors-counter-reserveSee here for more details and how to subscribe.


*Geof Mortlock, of Mortlock Consultants Limited, is an international financial consultant who undertakes extensive assignments for the International Monetary Fund, World Bank and other organisations globally, dealing with a wide range of financial sector policy issues. He formerly worked at senior levels in the Australian Prudential Regulation Authority and Reserve Bank of New Zealand.