By Matt Nolan
There has been some discussion of deposit insurance, the open bank resolution plan, and the types of risks being faced by New Zealand savers. This is actually a hugely important issue, and as a broad matter of principle I actually find myself agreeing more with Labour and the Greens than National and the Reserve Bank.
My view is that deposit insurance should be announced, it should be explicit, there should be certainty around it, and it should be treated as a form of “compulsory insurance” with the payment of an associated “insurance levy on debt financing” for financial institutions over a certain size. Of course, even with this the OBR still has a place (it is actually a very separate issue) – and that is why the RBNZ was right in saying this.
In order to see why this is the conclusion I’ve drawn, one that differs from current policy, let’s have a brief look at my thought process through a post.
Political equilibrium, credibility, and expectations
Bailouts are a topic that the government, Treasury, and the RBNZ are justifiably wanting to avoid talking about too much in public. Why this is justifiable, but the reason why we may need to be more transparent about it, comes from thinking about the expectations of people both within and outside of a bank run.
Governments and central banks are perceived by people in the economy to be the lender of last resort – due to a view on bank runs.
Having a functioning lender of last resort means that, in the worst case scenario, these institutions will act as a lender of last resort. In this way, the NZ government is expected to bail out large financial institutions (in the NZ case banks) if they fail.
Now on the face of it we might not like this. We don’t bail out other large companies. And with an implicit backstop, financial institutions will take on too much risk (and the people funding these institutions will assume there is far less risk) – this is the problem of moral hazard. In this way, the expectation of a bailout creates a difference between the “full social riskiness” associated with lending and the risk that private individuals and firms face when deciding to lend and borrow between each other, through a bank.
The Treasury, government, and RBNZ acknowledge this moral hazard issue – and so they want to introduce the open bank resolution policy settings as a way of avoiding bank runs (which is why we have deposit insurance in the first place), insuring the bankruptcy is orderly for financial institutions (to make the costs to everyone involved, from negotiating about who gets what, as small as possible), and limiting the number of situations where “bailouts” will really be required.
This is good, this is exactly what they should do. However, the scheme lacks three things when it comes to thinking about “expectations”:
1) Clarity about how losses are determined and split in a typical situation that requires bankruptcy – an issue that will be solved soon.
2) Clarity around how this links to the lender of last resort function of the central bank.
3) The political incentives to bail out banks.
Let us be honest here. The government will not let a bank fail. They will not let depositors lose money. It is in the government’s interest during a bank failure to have taxpayers pick up the tab. People know that the government will do this (or at least form expectations based on this) as so will lend to banks in a way where they are seen as riskless! There is an implicit deposit guarantee scheme for banks at the moment! This is the key point – even if we aren’t admitting it, there is a deposit guarantee running at present that we aren’t acknowledging.
As a result, it makes sense to turn around and make this explicit. Note: If the government thinks it can costlessly credibly commit to not bailing out institutions, and the RBNZ can solve the issue of bank runs without full deposit insurance, then this is good. But we do not have that right now, not in the slightest, and it should be admitted as policy-relevant.
This doesn’t seem particularly fair on the taxpayers
No it doesn’t. The taxpayer is essentially subsidising loans. The subsidy is then split between depositors, the banks, and the borrowers due to relative elasticities, information, and bargaining positions. Overall “too much” is invested due to what is socially optimal … this is where we have the “too much debt” business.
If we make the deposit guarantee explicit instead of implicit and we completely remove the loss from default – if anything it will exacerbate the moral hazard issue issue! So what do we do?
Deposit guarantees are a form of insurance. Generally, you pay for insurance with an insurance levy. If we have an explicit guarantee scheme on deposits, then there should be a levy on those deposits.
Yes this will reduce investment, yes this will see lower returns to depositors, but without doing this we have a deposit guarantee scheme that just costs everyone in NZ and in turn makes the entire financial system more unstable.
The kicker with all this is that the insurance scheme will have to be compulsory for all institutions over some type of nominal size. The type of bank failure we are concerned about, and which will lead to bailouts, stems from an episode where there is systemic risk to the banking sector as a whole.
In that case the incentive to take on the insurance for an individual firm does not match the full social return associated with it. Furthermore, if the bank decides to take on insurance it may be seen as a signal of weakness (given asymmetric information) making banks unwilling to take on the insurance for signaling reasons. Finally, the political eqm argument suggests that a government may well bail out the bank irrespective of whether they have taken on the insurance – making a bank unwilling to pay for insurance they can expect to get anyway.
At the moment there are two ways forward when thinking about banking policy in NZ:
1) Explicit deposit insurance, with an associated deposit levy.
2) A credible commitment by government that it won’t guarantee deposits combined with RBNZ regulation that can avoid bank runs.
Current policy is trying to push towards the second (which is admirable), but in the current environment I do not believe it is credible given the idea of “political incentives”. Which is why I find the idea of explicit deposit insurance combined with a deposit levy to be the best way forward.
Note: Concern about levies is a fair point. If we are the only country “not subsidising”, what does that mean for us? I’d note that the big runs here come from trying to introduce this during a crisis – it doesn’t rule out the effectiveness of the policy outside of a crisis. In a number of ways this would be similar to the FDIC – just with appropriate insurance premiums (which are ex-ante pretty danged hard to determine), and with an appropriate scale to ensure that the government can commit to no more additional bailouts.
Note 2: Good post by Eric Crampton stating why he thinks the government can commit.
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.
Note 3: The Economist points out research by the IMF that shows explicit deposit insurance makes the moral hazard problem more acute – this is a pretty easy to understand idea, and we mentioned the concept above (just under our second subtitle). This is why we both require a levy, and have to accept that it is “inefficient” relative to a situation where the government commits to not bailing out banks AND we have a way to prevent bank runs (where by this I mean optimally reduce the probability of a bank run so the expected cost of it happening is equal to the expected cost of introducing preventative measures). If we can do that second bit – then do it, and scrap the compulsory insurance.
This article was first published on TVHE and does not necessarily represent the views of Infometrics as an organisation.