NZX Chief Executive Mark Weldon and NZ Institute CEO David Skilling have argued in their discussion paper "Swan dive or belly flop" that the New Zealand government should demand its "pound of flesh" for taking on the risk of providing retail and wholesale deposit guarantees for the Australian-owned banks here. Weldon and Skilling have said in the latest draft of the report that the banks should have to agree to raise capital from government-owned pension funds and the public through floats on the NZX. The government should also demand options to own up to 25% of the New Zealand arms of the Australian banks if the banks face collapses that would endanger deposits, they argued. "The asymmetry between the risk the New Zealand taxpayer takes from having and insuring an entirely overseas owned banking system, and the returns from that risk (limited to the orderly functioning of a banking system and corporate tax paid only) creates some fundamental issues in tail-event situations like we are currently experiencing," they said. Weldon and Skilling acknowledged the government had to act to follow Australia in developing the existing schemes, which were now well crafted. It was also likely to strengthen the Reserve Bank's monetary policy making powers because of the likely incentives from the scheme for borrowers to go for variable rates rather than more expensive fixed rates.
" However, it is also likely these new changes will result in either capital being re-allocated by the banks to higher return jurisdictions and/or, these charges will pass through to New Zealand households and firms so that bank profitability is not impacted negatively by the scheme," they said. "There is a potentially large misalignment between the right answer for the New Zealand economy, and the equity holder of the Australian banks. Lets therefore look at the potential risk the taxpayer is now insuring. It is highly concentrated, highly correlated, non-diversified and potentially bigger than our ability to pay," they said. "If we were an insurance company, we would lay that risk off onto the re-insurance market. The New Zealand Government, however, has no ability to lay off this risk. Risk that is this concentrated has a name in finance - it is called equity-level risk." The US and other governments had only taken such risks with the reassurance that came from demanding equity stakes in return. "The New Zealand Government is not a commercial insurer, is not in this for a return, does not want to be in this business, and is not taking risk (tail event) for which a premium can fairly compensate it. As the risk side of the equation for New Zealand is growing, so should the return and, like the U.S., UK, Germany etc., New Zealand should extract a fair pound of flesh for the benefit of access to sovereign risk if a tail event should occur," Skilling and Weldon said. "From a New Zealand taxpayer perspective, we should have "skin in the game" for taking on this risk." They outlined two options which should be added to the scheme as conditions that would apply, should the insurance actually be called. "First, require each bank that opts into the wholesale insurance scheme to float a minimum of say, 15-20% of New Zealand businesses. Of this new capital of 10% could be offered first to the NZSF, which may elect to take a long-term ownership position in these cornerstones of the New Zealand economy (legislative change to NZSF legislation required here); and offer the rest first to New Zealand residents. This float would have three benefits. First, it would shore up the equity capital base of the New Zealand banks - reducing their risk profile in terms of the risk that the New Zealand taxpayer is taking on these banks and reducing the moral hazard risk that reduced profitability in New Zealand due to insurance scheme costs will lend to capital being allocated away from New Zealand to high reform destinations. Second, it puts a market value on the equity of each of the New Zealand banks. Third, through new equity capital raised, it lowers the risk of default," they said. "The second option, either combined with the above or independent of it, would be for the New Zealand government to take an option on, say, 15-25% of the equity of each New Zealand bank that opts into the scheme, which, in the event of the government having to pay out on the insurance, it would have as a call option. New equity would be issued to the New Zealand government at a price at a deep discount (say 25%) to the trading price at such point in time as any deposit insurance scheme was invoked," they said. "This would give the New Zealand taxpayer some upside for stabilizing the operation. If any bank chooses not to opt into this wholesale deposit scheme, then these provisions need not apply." What I think I'm sympathetic around the idea of the government buying a deeply discounted stake if necessary to rescue the banks, rather than writing them insurance that can't realistically be funded without massive tax increases for years. This is an equity type level of risk that should be matched with equity ownership. I'm not so sure about forcing the banks to float here and forcing the NZ Super fund to invest in the banks. I don't think our market could handle 10-15% stakes, even with the NZ Super Fund's involvement. It would be fantastic for the NZX and if the Aussie banks were that desperate they needed injections they wouldn't be in a position to argue. All of this is very likely to be moot, however, given the chances of failure are very, very low in my view. Your view? Comments below please