Thursday 21 March 2013

Deposit Insurance

New Zealand did not have deposit insurance going into the Great Financial Crisis. In the middle of an election campaign, and terrified that the failure of some finance companies could lead to worse things, the government made what I thought at the time and still think were some pretty bad bailout decisions. The potted history is here; more detail here.

The financial crisis now being over, the deposit guarantees scheme has been wound down in favour of Open Bank Resolution. The RBNZ has a primer on it here; here's their FAQ; here's more detail. But here's my version, keeping in mind that I really really am not a banking regulation expert. When a bank goes into statutory management for insolvency or other serious problem, OBR first freezes a portion of depositors' accounts while keeping the bank open. They then burn the shareholder equity and the unsecured bondholder funds. If that covers it, depositors are fine and everything's unfrozen.* If the bank still doesn't have enough to cover the depositors' claims, the depositors take a haircut.** [Update: this is incorrect. Depositors are among the unsecured creditors and are burned at the same time, albeit only fractionally. Consequently the expected haircut for depositors is larger than I had expected. ]

It's a pretty nice setup. There's no banking holiday, all the banks keep running while OBR is underway. The incentives are set up correctly so that those with most control over how banks run their book are the ones burned first if things go wrong.***

Matt Nolan provides the best critique of the whole thing. In short, he doesn't think the government can credibly commit to letting depositors take the haircut. Taxpayers will be on the hook if something bad happens, there's nothing we can do about it, and we might as well force banks to pay for insurance now because they'll get bailed out later regardless.

I think he's got the best argument against OBR, but I put a bit better than even odds that he's wrong. Why? Bailout pressure is endogenous to the risk imposed on depositors. And a bank would have to be in pretty rough shape to wind up imposing any substantial haircut on depositors after having burned the unsecured creditors and the equity. Now the unsecured creditors and equity holders could work pretty hard to convince the depositors that the haircut would wind up being really big so that they could pressure the government for a bailout that would also protect the big guys. But the first-stage deposit freeze would be an upper bound on depositor losses and anchor expectations.

Further, consider the government's approach to bailouts consequent to the Canterbury earthquake. The government refrained from bailing out anybody who hadn't purchased insurance and even, arguably, imposed a massive taking on red zone owners of bare uninsured land - despite plenty of very real very sad stories in the Press about the consequences.

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.

It's worth re-reading Rod Carr's speech on the topic from 2001. Open-Banking Resolution seems consistent with the goals he there outlined.

* I hate "unfrozen". But "thawed" just doesn't seem right. Again, I'm not a banking reg guy.

** Secured creditors seem ahead of depositors in priority of claim; I'm sure that there's some really good reason for this, but I'm not a banking-finance guy. I'd have thought depositors' claims should have been ahead of all others, so there must be a good reason that they're not. Presumably this is a margin on which banks could compete, if depositors cared about it: lower interest rate payments in exchange for being less likely to take a haircut if bad stuff happens. It would have made more sense to me that there be some mechanism for converting secured creditors' assets to an equity interest for recapitalising the bank. Again, though, totally not a banking reg guy.

*** I really liked @PaxDickinson's tweet. It recognizes the importance of incentives. Again, see my masthead:


  1. I went into ANZ. I said I want an account. I gave them passport, birth certificate, marriage certificate with living address. Also two utility accounts being Contact energy and Telstra clear with internet addreses on them. The blonde rang some paranoid pink shirt in had office and then she said I am sorry but we do not have sufficient proof of your address.
    I said why don't you come and sleep with me for a few nights and see if you believe I live where I do. Close my account woman.
    After that I went to a party and we started talking about Banks, and I found out how much New Zealanders hate Australian banks. Some of them were with paypal, some with building Societies, one even had gold, but we all hate Australian banks

  2. Eric: Good point about the Canterbury quake, but would a Labour/Green govt also have not bailed out ChCh?

  3. They'd have been tempted to, there'd hopefully have been strong push-back from the bureaus about how you can't pay out people for insurance they didn't buy unless you want to make insurance mandatory afterwards.

    I think they had bailed out the finance companies because they were caught scrambling when Oz put in deposit insurance, nothing was really in place here, and everybody was scared all funds would flee to insured accounts over there. Having the pre-set disaster plan makes bad responses to disaster less likely - I'd have thought.

  4. The better comparison I suppose would have been with AMI Insurance. There, they should have gone with a haircut and didn't.

  5. I'd have thought depositors' claims should have been ahead of all others, so there must be a good reason that they're not.

    I recall Rod Oram mentioning this on one of his NatRad Business columns a month or two ago. It is a recent tweak which went below the radar, where term deposits got knocked down the creditor chain but without an interest bump to reflect the increased exposure. Another cunning scam enabled by the Nats.

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