By Geof Mortlock*
Recently, I wrote two articles on banking related matters. One was on the Reserve Bank’s proposal to increase bank capital requirements to levels that are much higher than in other countries. The other was on a completely different topic – the need for New Zealand to establish a deposit insurance scheme to protect bank depositors if a bank fails.
Some readers have asked the question: Is bank capital a substitute for deposit insurance? In other words, if the Reserve Bank’s proposal to increase bank capital requirements to very high levels is implemented, will this obviate the need for deposit insurance? The short answer is ‘no’. And this article explains why the answer is no – i.e. higher bank capital ratios are not a substitute for deposit insurance.
What does bank capital achieve?
Capital in a bank provides a buffer to absorb losses. If it takes the form of equity (e.g. ordinary shares and retained earnings) or a debt instrument that converts to equity upon defined events (such as a bank’s capital ratio falling below a defined level), then this provides a means of absorbing losses while still enabling the bank to continue trading – it is known as ‘going concern’ capital. All else being equal, the higher the level of capital relative to a bank’s assets, the greater the amount of losses that a bank can absorb while still keeping its doors open. Put another way, the higher a bank’s capital ratio is, the lower is the probability of the bank defaulting on its financial obligations – i.e. failing. However, unless the capital ratio is 100% (i.e. there are no deposits or other liabilities, which would be an absurd outcome), then the probability of failure will never be zero. Capital can reduce the probability of a bank failing, but it can never eliminate the possibility of bank failure.
Of course, other factors come into play when determining the probability of a bank failing. Crucially, the quality of a bank’s governance and risk management will play a major role in determining the probability of bank failure. A bank with poor governance, high risk appetite and deficient risk management systems will have a much higher probability of failing than a bank with good governance, conservative risk appetite and high-quality risk management, if their capital ratios are the same. Indeed, when one looks at the history of bank failures around the world, and in New Zealand, the key factors causing banks to fail were poor governance, a high appetite for risk (e.g. risky lending and high concentrations of loans to one sector or counterparty) and poor-quality risk management systems and controls. Even banks with relatively high capital ratios have failed because of these causes. It would have taken extraordinarily high capital ratios to have avoided the majority of bank failures over the decades - globally and in New Zealand.
This is why bank supervision authorities in most countries place so much emphasis on bank governance, risk appetite and risk management, as well as on capital, liquidity and other factors. They have prudential standards focused on these matters. They have comprehensive monitoring of these matters. They conduct regular on-site bank assessments on these matters. And they have staff with in-depth expertise in bank governance and risk management.
In contrast, the Reserve Bank has very little of any of this. They prefer a ‘light touch’ approach to supervision. What does this mean? In essence, it means the Reserve Bank has adopted a relatively lazy way of supervising banks; it prefers to place reliance on ‘market discipline’ through disclosure, limited-scope off-site monitoring and, now, a huge increase in capital ratios. For years, the Reserve Bank has eschewed a meaningful approach to bank supervision – they are almost theologically allergic to it. Their preference now is to place most of the financial stability eggs in the capital basket – to seek to reduce the probability of bank failure through very high capital ratios, rather than roll up their sleeves and actually do a professional job at bank supervision through a more balanced set of tools.
What is the consequence of the Reserve Bank’s approach?
The Reserve Bank’s lopsided approach to bank regulation – so much weight placed on capital and so little on anything else – is that it will have a significantly adverse impact on the efficiency of the financial system to the detriment of the economy and bank customers. Very high capital ratios will, in all probability, increase interest rates, reduce the appetite of banks to lend and reduce the availability of credit to the economy. It is also likely to reduce the contestability of the banking system by discouraging foreign banks from entering New Zealand. This will reduce competition to the detriment of bank customers (depositors and borrowers) and the wider community. High capital ratios will also create a risk of what is called ‘disintermediation’- i.e. a process whereby lending and other capital-using bank business moves from the regulated sector (the registered banks) to the lighter regulated sector (the non-bank deposit-takers) or even to the non-regulated lending sector. Again, this is detrimental to the efficiency of the financial system and could pose additional risks to borrowers if they come to rely on non-regulated lenders for access to credit.
A more balanced approach to regulation would reduce these adverse outcomes. It would achieve financial stability outcomes at lower costs in terms of adverse effects on financial system efficiency, access to credit and resource allocation in the economy. What would a more balanced approach look like? It would involve:
- A more modest increase in capital requirements – considerably less than the Reserve Bank is proposing, and more aligned to international benchmarks. Any increase in capital ratios would be informed by rigorous bank stress testing.
- A more risk-based approach to bank supervision, where banks of higher risk are subject to more intense supervision and higher prudential requirements (e.g. on capital and liquidity) than lower-risk banks.
- Greater emphasis on bank governance, risk appetite, risk culture and risk management systems and controls – where banks with high standards in these areas would, on average, have need of a lower capital ratio than would banks that score less well in these areas.
- A requirement for banks to have recovery plans to enable them to restore themselves to financial soundness following a severe loss.
- A supervision authority with the culture, professionalism, skills and capacity to do the job properly. Sadly, the Reserve Bank fails badly on most counts. It lacks a genuine commitment to prudential regulation and supervision – its cultural DNA has always been dismissive of the need for prudential regulation and supervision. It lacks a senior leadership team with any expertise in financial stability and prudential supervision – not one of the senior leadership team has anything like the professional knowledge or experience needed to do the job. And it lacks the staff with the knowledge, experience and the tools to be effective supervisors, with a few exceptions.
What is needed is a fundamental re-balancing to address all of the above deficiencies. This would achieve the desired financial stability outcomes at lower costs to financial system efficiency and to the economy than the Reserve Bank is proposing. But that will not happen in the Reserve Bank as it currently exists. It will only happen if either the Reserve Bank is dragged (against its will) to a 21st century approach to prudential supervision, subject to robust accountability and much greater external oversight, or if the entire prudential function is moved to another organisation – a newly established Prudential Regulation Authority.
And where does this leave deposit insurance?
The level of capital ratio required of banks has no impact on the need for deposit insurance. As noted above, all else being equal, the higher the capital ratio is, the lower will be the probability of failure. However, the probability of failure will never be zero. Even in a highly capitalised banking system, bank failures can and do occur. Indeed, a banking system which had a zero rate of failure over the long haul would most likely be a moribund banking system; it would be one in which banks are unwilling to take risks and have no or very limited appetite to innovate. That is hardly the recipe for a healthy and vibrant financial system. And is not a financial system that is well placed to meet the needs of the economy and community. Indeed, a healthy, balanced banking system is one in which there will occasionally be a bank failure – hopefully rare and non-contagious. When it happens, we need a structure that provides an efficient way of resolving the bank – including giving depositors prompt access to their funds, protecting small depositors from loss, maintaining the continuity of systemically important functions and preventing one failure from triggering runs on other banks.
Deposit insurance is a key part of this structure. It provides the means for protecting small depositors – i.e. those who cannot, in all reality, protect their own interests through bank disclosures and the like. It provides a mechanism for prompt access to insured deposits, while still enabling other resolution processes to give prompt access to a proportion of larger depositors’ funds. It reduces the risk of inter-bank contagion by reducing the risk of depositor runs on multiple banks. If well designed, it makes higher-risk banks pay a higher level into a deposit insurance fund than lower-risk banks. And it takes the political sting out of bank failures, enabling governments to avoid the pressure to react in ad hoc and ill-considered ways, such as through blanket guarantees.
Higher capital ratios for banks do nothing to reduce the need for deposit insurance. At most, higher capital ratios might justify a lower target size for a deposit insurance fund, given that the probability of bank failure may be lower. In turn, a lower target size for the deposit insurance fund could justify a smaller deposit insurance levy than in a higher-risk banking system. But the need for deposit insurance remains. A good parallel is house insurance. The risk of damage to a house in any kind of disaster can be reduced through high standards of construction and building maintenance. But we still need house insurance. Why? Because we know that, even with the best standards for house construction, there is always a risk of damage due to fire, earthquake, flooding and the like. And it is the same principle in banking. We need deposit insurance for the times when, despite capital and everything else, a bank fails.
*Geof Mortlock, of Mortlock Consultants Limited, is an international financial consultant who undertakes extensive assignments for the International Monetary Fund, World Bank and other organisations globally, dealing with a wide range of financial sector policy issues. He formerly worked at senior levels in the Australian Prudential Regulation Authority and Reserve Bank of New Zealand.