What cover do you have if your bank fails?

OPINION: We live in a volatile financial world.

The global financial crisis reminded us of that when many banks in Europe and the United States became financially distressed or failed.

Some were rescued by the taxpayer and some were closed or merged with other banks. Similar financial crises have occurred in many countries over the decades, including in Asia, Europe, the United States and Latin America.

New Zealand and Australia have – so far at least – avoided severe financial crises. That said, we have not been entirely immune. In 1990, for example, the then largest bank – Bank of New Zealand - sustained major losses and had to be recapitalised by the government.

In 1989, DFC – a quasi-bank supervised by the Reserve Bank – became insolvent and was placed into statutory management.

Much more recently, between 2006 and 2012, more than 50 finance companies failed. As a result, many thousands of investors lost large amounts of their funds. By any standard, that was a disgraceful episode in New Zealand's financial history and a major regulatory failure.

Currently, New Zealand has a strong banking system. By international standards the banks in New Zealand are well capitalised. In most cases they have strong parent banks standing behind them – especially so in the case of the big four Australian banks that dominate our banking system.

In the case of the Australian banks, New Zealand also benefits from the high standards of supervision provided by the Australian Prudential Regulation Authority. Stress testing conducted by the Reserve Bank in New Zealand suggests that the banking system is sufficiently strong to survive relatively severe financial shocks.

However, no banking system is immune to financial shocks. Even in robust banking systems, occasional bank failures occur.

That is as true in New Zealand as it is anywhere in the world. We would be especially vulnerable if the New Zealand economy sustained severe and long-lasting shocks at the same time as Australia – which is an entirely plausible scenario.

NO GUARANTEE

The Reserve Bank supervises banks and regulates non-bank deposit-takers to promote a stable financial system. In effect, it seeks to achieve a low probability of institutional failure. But it does not, cannot and should not guarantee that banks or non-bank deposit-takers will never fail.

In such a situation, if banks were to fail, how safe are our bank deposits?

In most countries, if a bank fails, small depositors are protected from loss.

This is achieved by what is known as deposit insurance – a system under which depositors are repaid or their deposits are transferred to a healthy bank if a bank fails.

This is funded by a deposit insurance agency or similar arrangement. In Australia, for example, such a scheme fully protects depositors up to A$250,000 per depositor per bank. In Europe, the protection is 100,000 Euro per depositor. In the United States it is US$250,000.

And what is the amount in New Zealand? Zero.

Depositors in New Zealand have no protection in a bank failure. New Zealand is the only advanced country in the world without any form of depositor protection.

Indeed, the Reserve Bank has implemented a policy which could well force depositors to bear losses in a bank failure – the so-called 'Open Bank Resolution' policy.

The Reserve Bank has opposed deposit insurance on the grounds that it would reduce 'market discipline' on banks, because depositors would no longer have as much incentive to monitor their bank and either require higher interest rates for higher-risk banks or withdraw funds if they become concerned.

While that argument is relevant, it overlooks the reality that market discipline is more likely to come from large depositors and bondholders, rather than from small depositors. This is because large depositors and bondholders have the capacity to effectively monitor banks, and can quickly transfer funds if they develop concerns.

In contrast, small depositors – that is, most of us – lack the ability to effectively assess a bank's risk profile. By the time most of us become aware of a bank being in difficulty, it is often too late to do much about it.

When depositors do develop concerns, there is a risk of over-reaction – ie that they will panic into running on one or more banks. In the absence of being able to differentiate between healthy banks and unhealthy ones, depositors are prone to running on banks in general.

DEPOSIT INSURANCE

That is one of the main reasons why countries have established deposit insurance. It reduces the risk of uninformed depositor reaction and the banking system instability that can ensue.

When I worked at the Reserve Bank – many years ago – I shared doubts about deposit insurance for the same reasons now argued by the Bank.

But that was in a world where there was – in reality – a strong presumption of taxpayer bail-out if any major bank got into difficulty. That world has changed. Since the global financial crisis, many countries, including New Zealand, have developed policies that enable even large bank failures to be handled in ways that minimise the prospect of a taxpayer bail-out, by forcing shareholders, then creditors (including depositors), to absorb losses.

The Reserve Bank's Open Bank Resolution policy is designed to enable bank failures to be managed in this way.

It provides for a 'haircut' of creditors' claims on a bank, including deposits, to absorb losses and potentially to fund a recapitalisation of a failed bank. Some countries have similar policies.

However, one big difference between New Zealand and other countries is deposit insurance. In other countries, depositors are immunised from loss up to the defined coverage of deposit insurance. In New Zealand, they are not.

The Reserve Bank has indicated that its Open Bank Resolution policy could be applied in such a way as to exempt small deposits from loss.

However, there is no guarantee of this.

The decision would rest with the government of the day. And who knows what they might decide.

TAXPAYER FUNDING

Moreover, any such protection would either need to be funded by the taxpayer or by applying deeper losses on larger depositors and other creditors. Neither option is fair or sensible.

A further problem with the New Zealand arrangements is that Open Bank Resolution applies only to the larger banks.

It leaves great uncertainty as to how the Reserve Bank would manage the failure of a smaller bank or a non-bank deposit-taker. In such cases, there is a risk that depositors would not only sustain losses on their deposits, but might also be unable to access any of their deposits for several weeks or even longer.

The smart solution is for New Zealand to establish deposit insurance. This would not significantly reduce market discipline on banks. But it would have several important benefits, including:

providing small depositors with certainty that they are protected from losses up to a clearly defined amount;

providing depositors with prompt access to their protected deposits in a bank failure;

reducing the risk of depositor runs and resultant instability in the banking system;

reducing the political pressure on government to bail-out banks in distress – deposit insurance would actually make Open Bank Resolution more politically realistic.

Deposit insurance would be funded by the banking industry through levies. The cost could either be absorbed by the banks or passed on to depositors. In either case, the cost is small – no more than a small fraction of a percentage point per annum on each dollar of bank deposit.

The government should rethink its position on deposit insurance. The absence of deposit insurance creates a significant risk of financial instability. It also carries a significant risk for taxpayers.

Geof Mortlock is a former senior staffer of the RBNZ and Australian Prudential Regulation Authority, and a consultant with the International Monetary Fund, World Bank and Financial Stability Institute. He does consultancy work for KPMG Australia, and has his own consultancy firm www.mortlock.co.nz.