Tuesday 25 June 2019

Bailout risk and deposit insurance

It looks like New Zealand may wind up getting deposit insurance at the banks. 

Let's review the case for these.

If you think that the government is very likely to bail out a failing bank, then that bank and its depositors are currently enjoying an unpriced insurance product that allows the bank to take more risks than it otherwise would, with depositors and shareholders enjoying the upside benefits, and shareholders and the Crown bearing the downside costs. Recall that under New Zealand's OBR regime, shareholders are fully burned before any depositor funds are touched - I've not heard that there's bailout risk for shareholders. 

I expect that there would be substantial bailout risk in any bank failure where haircuts under OBR would be substantial, but haven't thought that risk material. It would take a very large bad event to make a bank go down at all, so maybe you could figure that conditional on a bank's failing, the losses are likely to be more substantial than OBR could safely handle - it's not a crazy view at all. I've tended to think that there's trivial bailout risk for haircuts on the order of 10%; other economists whose views on this stuff I respect think that even a 10% haircut would trigger a bailout. They may not be wrong given precedents in Christchurch insurance. 

So it's really one where you want to be all in or not at all. The Bank and government could push hard to maintain the position described by Rod Carr when he was Deputy Governor about that bailouts simply wouldn't ever happen, and maintain expectations around that equilibrium to make it self-enforcing. But piles of economists speculating about the likelihood of bailouts and saying that they'd be likely to happen can unwind that too. 

Mandating deposit insurance and pricing it appropriately will reduce depositor returns, but if insurance makes sense, that's only because depositors will have to start paying for something they were already getting for free from the government. 

But what seems a bit nuts given all that is National's line critiquing the government. Again, from the background above, there are tenable arguments against the government's position. You could argue that we need hard lines against bailouts. You could argue that prudential regulation and results of existing stress tests mean bailout risk is low because the probability of failure is low, so any resulting insurance costs should also be reasonably low - and that all of this should be considered simultaneously with the coming changes to bank capitalisation requirements rather than on their own. 

Those aren't the arguments National's running. Instead, they're angry that the deposit insurance doesn't protect people who have a pile of money sitting in bank deposits. The government's proposal would cap protection at between $30,000 and $50,000. National thinks it should have a much higher threshold, and worries about people who have their entire retirement savings in bank deposits.

The model of deposit insurance and bailout risk in my head is that bailout risk is sharply increasing in the number of small and relatively poor depositors who lose their shirts in a bank failure. They could credibly say that they trusted in the government's prudential supervision and would be in a very poor position because of the failure. Someone with a couple hundred thousand dollars sitting in a deposit account would likely hit the 'informed investor' triggers in other areas - in other words, people who should really really know better than to leave lots of money sitting in deposit accounts for substantial periods of time.

What model of bailout risk must be in your head to think that the government is especially likely to bail out a pile of rich people who really should have known better? Is National really here saying "Yeah, we'd totally do an SCF bailout again, you've got to price that kind of thing in because we can't help ourselves from bailing out rich people who should have known better"? All explanations are depressing. 

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