Taxpayer guarantees for bank deposits are a can of worms. There should be a strong presumption against them.
Those who chase higher returns should bear the risks themselves. Those who want government protection can invest directly in government-backed investments or institutions.
That is the thrust of The New Zealand Initiative’s submission last fortnight on a Treasury/Reserve Bank paper seeking feedback on taxpayer-guaranteed bank deposits.
There seems to be a fuzzy idea that depositor confidence is always a fine thing. It is not. Confidence about a bank’s soundness is dangerous – if misplaced. Taxpayer guarantees are bound to be mispriced due to inadequate information and flawed political incentives. Mispricing induces misplaced confidence.
The guarantee proposal is live because the International Monetary Fund recently commended it to New Zealand authorities. Apparently, most other countries have imposed some form of deposit insurance.
Following other countries
That is a poor argument for us. Other countries force taxpayers to subsidise everything from coal to farming. New Zealand does not have to follow suit.
Bank bailouts for risk-takers are particularly invidious. Public outrage is still palpable over the bailouts globally during the 2008–09 global financial crisis, and rightly so. Factors that contributed to a cavalier attitude to risk were the ‘too big to fail’ philosophy among central banks from the 1990s and the so-called ‘Greenspan put’ that saw the US Federal Reserve underwriting high-asset prices.
Neither has New Zealand been exempt from folly at the taxpayers’ expense. Atrocious electioneering saw New Zealand’s fourth Labour government force taxpayers to bail out depositors who chased the higher returns offered by finance companies. There was no good public policy reason or effective accountability to Parliament. The failures did not pose any threat to New Zealand’s financial system.
Weighty empirical research also finds that bank deposit insurance commonly increases the risk of systemic bank failure, exactly what we need governments to guard against. The reason is obvious: If taxpayers bear the risks without any returns, depositors and bank managers will probably chase higher returns.
A Treasury seminar last week featured a visiting overseas expert on the subject. He was an advocate of blanket taxpayer liability for smallish-scale bank deposits. His job was in deposit insurance, so he was not a disinterested party.
His presentation did not mention this disturbing research. However, in question time he showed he was familiar with it. He discounted it on the basis that governments have learned the lessons. He was confident that well-designed schemes would do more good than harm.
It goes without saying that a well-designed scheme should produce better outcomes than an ill-designed scheme but this does not mean their benefits are greater than their costs.
Neither does it mean vote-seeking political processes in New Zealand would produce a well-designed scheme. Even his presentation showed current international practice was a hodgepodge of flawed approaches. This is no surprise – political processes are murky.
Every scheme requires a large number of decisions that can only be determined through political processes, one way or the other. Politicians have to assess which institutions will be covered, what type of deposits will be covered and to what extent, whether coverage is to be mandatory, who will pay any insurance premiums, whether those premiums will reflect risk differences, and if so, how risk will be assessed. Moreover, initial decisions will be endlessly relitigated in the light of changing circumstances and political opportunities.
To his further credit, the presenter was clear the norm was for deposit insurance schemes to be underfunded relative to the insured risk. That alone should be a red light for taxpayers.
Perhaps the strongest argument for a government guarantee is the assertion that future governments will bail out retail-scale depositors anyway. Arguably, an explicit pre-committed bailout may be better than one created on the hoof. In addition, the government might get revenue from any premium charged along the way.
Failure is positive
This is really a case for making it harder for future governments to bail out deposit-taking institutions whose failures pose no systemic risk. After all, bank transaction balances are commonly only a small portion of household wealth, and the welfare state already exists to help people experiencing hardship.
Moreover, failure is a positive feature of a competitive system. It is only by failing that systems discover what does not fail. All can learn from failure. And New Zealand’s Open Banking Resolution framework substantially protects depositors if a bank should fail.
A critical point is that New Zealand already has extensive government regulation to protect what really matters – continuity of the payments system. The measures include capital adequacy ratios and special insolvency measures designed to keep a bank open while imposing ‘haircut’ disciplines on those who assumed risks.
Layering additional deposit insurance protection on top of those existing measures is probably overkill. Even the existing measures may be overkill, given the absence of any clear benefit-cost justification. All our major banks have cornerstone shareholders of real substance in any case. It is not clear how this strength is factored into the existing stress tests.
The bailout of the partially privatised Bank of New Zealand in 1990 showed the importance of corner shareholder strength.
Deposit insurance is one thing, banking system strength is another. On the evidence, the former probably undermines the latter.
Dr Wilkinson is a senior fellow at The New Zealand Initiative.