NZ doesn't have deposit insurance due to moral hazard and the difficulties of defining boundaries and pricing, but it could easily be accommodated, RBNZ says

Moral hazard is a key reason why NZ depositors don't have insurance, the RBNZ says. Image sourced from Shutterstock.com

By Gareth Vaughan

New Zealand depositors lack the insurance present in many other countries because the dangers of moral hazard issues and the difficulties of defining boundaries and pricing are viewed by officials here as bigger concerns than consumer protection, the Reserve Bank says, noting, however, that it could easily be accommodated.

In a speech entitled Handling banking failures delivered to the Institute of Directors in Wellington, the Reserve Bank’s head of prudential supervision, Toby Fiennes, said deposit insurance could "easily" be accommodated within the central bank's toolkit including the incoming Open Bank Resolution (OBR) Policy, which is designed to deal with bank failures.

"New Zealand does not currently have deposit insurance, for reasons that are more to do with moral hazard and the sheer difficulties of defining boundaries and pricing than consumer protection," Fiennes said. "We believe it is better to keep the risk of failure very low, including through a strong regulatory framework, than to build structures that can distort incentives and behaviour."

"If, however, deposit insurance were to be introduced, it could easily be accommodated within our toolkit of OBR and other crisis measures. It is not a case of choosing between one or the other - they have different objectives and can work alongside one another if need be."

The current government doesn't want to introduce deposit insurance, an issue that flared up after the recent collapse of the Cypriot banking system. Prime Minister John Key says a deposit guarantee scheme would prove too costly for consumers because banks would pass on the cost of any deposit insurance levy to consumers.

Labour, Greens want deposit insurance

However, things may change if Labour and the Greens get into power. Green Party co-leader Russel Norman wants an Australian style deposit guarantee scheme and Labour's finance spokesman David Parker says a Labour-led government would ensure the first NZ$30,000 of all bank deposits were protected and not subject to a haircut in the event of a bank failure. Norman says NZ$100,000 is a "fair level" of protection for New Zealand savers.

In his speech Fiennes said he wanted to stress that New Zealand banks are sound and stable and the Reserve Bank sees the risk of failure currently as very low.

"But there’s always the remote possibility that a bank does get into trouble, at some point. If that happens there are no simple solutions. It will be messy, people will lose money and how it is dealt with will depend on circumstances at the time," said Fiennes.

"OBR is a tool that gives government an additional option to taxpayer bailout or liquidation. It is not the only option that will be available on the day. Its mere existence provides important incentives for bank shareholders and management to minimise the risk of failure."

Fiennes said deposit insurance usually involves the establishment of an insurance fund, to which banks contribute.

"There are many different variations on, and within, that basic framework, but OBR can cope with all of them. For example, if there’s an insurance fund, the fund itself could stand as a creditor in the OBR. This is how the FDIC (the US deposit insurer) is treated in failed US banks."

He said there were three reasons why New Zealand doesn't have any form of deposit insurance or deposit guarantee;

 – Deposit insurance is not always effective in preventing bank runs by retail depositors. UK-based Northern Rock suffered a classic retail run in 2007, despite a deposit insurance scheme being in place.

– Deposit insurance is hard to price accurately and fairly, and brings with it difficult boundary issues. Should it be just for banks – as is currently the case for OBR – or should it also include finance companies, building societies and credit unions? How would we ensure that the least risky banks do not end up subsidising the more risky?

– Deposit insurance will increase moral hazard, making the banks more susceptible to failure, which brings with it the need for more, costly regulation. Where losses suffered by a bank are very large, the magnitude of claims may overwhelm the resources of a deposit insurance fund.

'Not a one-way street'

Fiennes said it was also unlikely that deposit insurance would prove to be a one-way street.

"Once it is put in place, it would be difficult to remove. On the other hand, some form of depositor protection arrangement may make it easier for the government of the day to impose a resolution such as OBR that does not involve taxpayer support – in effect the political “noise” from depositor voters is dealt with," said Fiennes.

He also pointed to a recent paper by World Bank staff assessing how deposit insurance affected bank risk. Drawing on data across 96 countries during the pre-global financial crisis (2004-06) and crisis (2007-09) periods. They conclude that the “moral hazard effect” dominates in good times, in that the existence of a deposit insurance scheme does lead to riskier behaviour by banks, Fiennes said.

"During a crisis, bank risk is lower and systemic stability greater in countries with deposit insurance coverage. By comparing the magnitude of both effects, they conclude that 'the overall effect of deposit insurance over the full sample remains negative.' In other words, they conclude that a deposit insurance framework increasing the likelihood of bank failure is a greater concern than the absence of an insurance framework worsening the impact of a crisis," said Fiennes.

This Reserve Bank of Australia sourced chart, (below), shows details of deposit guarantee, or insurance, schemes on offer in other countries

OBR 'a mechanism for reopening a bank very rapidly after a failure'

Fiennes also set out to explain, and defend, the OBR policy. The primary purpose of it was to ensure the financial system continued to function as smoothly as possible by keeping payment systems open so people and businesses could transact with each another.

"It is, as its name implies, a mechanism for reopening a bank very rapidly after a failure event. There is detailed information on our website about the process so I won’t go through it in detail now. In outline, when a bank is in trouble and we think it is unlikely to be able to meet its obligations in full and/or on time, it will be placed into statutory management. The statutory manager will legally freeze the bank’s liabilities. The basic idea is to release transaction accounts to the bank’s customers as swiftly as possible so they can carry on making and receiving payments," said Fiennes.

"Instead of their accounts being frozen for a lengthy period as they would under a conventional liquidation, a proportion would be unfrozen and released for the start of the next business day (with a government guarantee to prevent further runs on the bank). Non-transaction accounts would be released, also in the same proportion, in line with their maturity. The frozen funds would be released in whole or in part as resources are available," Fiennes added.

New Zealand's registered banks are required to pre-position their systems by June 30 this year so the OBR process can operate, if it's ever activated. The Reserve Bank has previously said OBR could save taxpayers' more than NZ$1 billion whether there's a bank failure or not. It estimates pre-positioning is costing the banking industry an initial investment of NZ$20 million, plus a net cost of NZ$1 million per annum for ongoing maintenance.

An alternative option

"OBR is about keeping a bank open and providing the government with real alternatives to liquidation or full taxpayer bailout – both of which may be totally unpalatable. It facilitates a rapid and orderly resolution of a bank failure. It does so without changing our basic legal framework around ranking of creditors in a wind-up or insolvency. In particular: It does not change the fact that depositors’ and other creditors’ funds are at risk," said Fiennes.

"It is a well-established legal principle that people stand to lose money if a business that owes them money cannot meet all its obligations. Banks are the same as any other business in this regard."

Nor does OBR change the ranking of creditors.

"Shareholders will be the first to lose their investment. Once shareholder funds are exhausted, subordinated creditors bear losses, followed by all other unsecured creditors on a pari passu basis, meaning that those with an equal legal claim get equal treatment. This is the same as in a liquidation."

Fiennes went on to say "the mere presence of OBR in the toolkit will impact expectations of government support." Nonetheless, he acknowledged OBR would not be the only option in a crisis.

"A government could still decide to bail out a bank or allow a bank to go into liquidation, if it felt the risks of doing so were small. But it is critically important to have a tool such as OBR in the crisis toolkit, to maximise options for the authorities on the day," said Fiennes.

(Update adds further detail).

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29 Comments

"New Zealand does not currently have deposit insurance, for reasons that are more to do with moral hazard and the sheer difficulties of defining boundaries and pricing than consumer protection," Fiennes said. "We believe it is better to keep the risk of failure very low, including through a strong regulatory framework, than to build structures that can distort incentives and behaviour."
 
Is that so Mr Fiennes?
 
I guess you actively demand our local banks cease and desist from funding excess asset creation from offshore lenders based in G3 jurisdictions, where local central banks actively pursue ZIRP and purchase term government securities to flatten the yield curve amongst other market distorting objectives.
 
The Fitch report also highlighted perennial issues raised by credit rating agencies over major New Zealand banks' reliance on offshore wholesale funding markets. Fitch estimates the big four source between 35% to 40% of their funding from wholesale markets.

Here's Russel Norman's response to the Fiennes speech:
New information released by the Green Party today shows that New Zealand is
one of only two countries in the OECD that does not protect bank savers’
deposits with insurance.**

The new information from the Parliamentary Library was released in response
to today’s Reserve Bank speech today defending the Government’s plans to
leave savers vulnerable. It shows that New Zealand and Israel are complete
outliers amongst developed countries by not offering deposit insurance to
protect savers’ funds should a bank fail.**

“If National implement Open Bank Resolution as planned, everyday people’s
savings can be made available to bail out their bank if it was to fail,”
said Green Party Co-leader Dr Russel Norman.

“This is almost unprecedented in the developed world.

“Open Bank Resolution allows our major banks to get off scot-free from
having to pay insurance premiums to protect their customers’ savings –
premiums banks have to pay everywhere else.”

Toby Fiennes, head of prudential supervision at the Reserve Bank, repeated in
a speech today the Government’s belief that deposit insurance increased the
likelihood of bank failure and distorted incentives. However, banking experts
Dr David Tripe and Dr David Mayes disagree, saying a deposit guarantee scheme
would be fairer.

“Deposit insurance isn’t designed to prevent bank failure; it’s
designed to protect small investors who don’t have the ability to assess
the risks their bank is taking with their savings,” Dr Norman said.

“Australia protects depositors’ savings up to $250,000. Other countries
have a lower threshold, typically around $100,000.

“We think $100,000 is a fair level of protection for New Zealand savers.

“A deposit insurance scheme wouldn’t add additional costs to savers if we
had a competitive banking sector, but we don’t, so it’s likely the banks
will pass some of the costs of the scheme onto its customers.

“This is a small price for people to pay to secure their life savings.

“A deposit insurance scheme is a much simpler, well-tested alternative to
the ‘haircut’ proposed by National. It rewards safe banks with lower
premiums and limits the cost to taxpayers of a bank failure.

“Cyprus has shown that taking savers money to bail out a failed bank
doesn’t work, so Open Bank Resolution is likely to be a taxpayer funded
bank bailout in the end, despite Bill English’s assurances,” Dr Norman
said.

Russel Norman really is an idiot of the first order, busily buying (pork barrel politics) votes instead of showing real understanding and from that leadership...what a failure....
regards

Stevo , I looked at this earlier today and saw your disillusionment with Russell, but mate honestly, if he doesn't pull the vote through the conventional keyhole ....he's not gonna do s%*t come election time....tactically I think he's got right, engage the audience, don't preach down to them.....
Cassandra gets a new dress.....and people take some notice.
 Cheer up Bucko....things could always be worse...you could be rooming with Kimy.

Not just this piece....I understand what your saying as Ive been wondering WTF has been going on since the election and if this was the case.  I just dont have the confidence that this is the game plan myself.  If it is that convoluted then Ok, however how will those who voted Green based on this clap trap will feel if it isnt delivered?  The Reason I liked the Greens was the Green bit and their relative honesty, maybe its truely got that bad that an honest man/woman cant get elected these days.
regards

maybe its truely got that bad that an honest man/woman cant get elected these days.
 
Well Stevo, just as an exercise, run through a list of 20 MP's that come to mind foremost.
Rate those MP's on honesty as a perception (personal)
Then try to recall MP persons that you may have percieved honest (overall) such as Ron Marks....and you'll probably get the idea quickly they tend to dwell on the fringes, become suffocated  by the bureaucracy involved in change , resigning themselves to going through the motions, picking up the paycheck, idely watching their values slip away.
I think Norman , has an awareness of this syndromic behavior, and has determined to play it by their (the controlling politicians)  rules.......
It is becoming harder by the week for the Nats to slag the Greens as pixieland people, because Norman is so often in their face , playing the game with credibility.
Let me ask you a direct question....do you think Norman.......(A) Totally honest..(B)overall honest  (C) a bit honest....(D) not honest, therfore not to be trusted.
Done.?
Well if he scored (A) he's dead meat, (B) he's Phill Goff (say no more) (C) probably a good bet with a sporting chance of survival to create policy ( D) He's going to be P.M. one day........
Because we get what we expect....is us that have to change in order for change.

If a Bank employee makes loans outside their Banks credit policy or was reckless you can bet they would ether loss their ability to lend or their job. I have seen it!!!

Banks are making 50% to 100% profit on money
Exactly how do you come to this conclusion?
Some numbers please?
and not just this 9 x fractional lending stuff.
(I suggest you look and a bank's balance sheet and tell me what are the  non interest bearing liabilities which might help?)
Also food for thought who pays the insurance on my house / car etc  and who benefits in the event of a claim?

Why would Deposit Insurance be any diffirent?

I would think you'll find the banks actually collect a % from the borrowers as an insurance fee if they can and then self-insure!
blah...its all rubbish.
So what you are saying is as a depositor you should be risk free? what then encourages you to be circumspect with your money?
Depositors take the loss because they have put their money at risk for a gain...all investment is a risk. So I fail to see why one group should enjoy a risk free status at someone (and thats usually an innocent ie the tax payer) elses cost.
regards

Snippy ...stop that...! your going to drag Steven to the poor house....how bout uranium..?
 how bout that eh....fairly stable  (pardon the pun)....
http://uraniuminvestingnews.com/14083/uranium-spot-price-stability-sign-of-a-turnaround.html
 

Ha ha Ha....!.....as you'll find out if he slips up....Not.!
But really Snippy diversify, if you bought into your position high...tough it out for sure , but to dig in further....can be disasterous.
 

Actually Im a firm believer in the metal that counters uranium, lead.  I mean if you believe in the day of the SHTF where you trade gold for food then really its all gone in a zombie nightmare and you'll need lead far more than gold.  Or alternativley you could seek medical help, far cheaper I would think.
regards

"in that the existence of a deposit insurance scheme does lead to riskier behaviour by banks" states Toby Fiennes. Is this because banks are allowed or can pass the cost on to their depositors? If that is prevented, then banks will become more directly responsible for their behaviour through the cost of the premiums, thus it may be argued that by being more responsible, and being able to demonstrate that, then the premiums will be lower.

Deposit insurance encourages risky behaviour by lenders because depositors can chase yield without taking any additional risk. It breaks the fundamental risk/ reward relationship which is supposed to underpin investment decisions.
Lenders then have a source of funds with which to chase lending at the risky end of the spectrum. This is what lay behing the savings and Loans catastrophe in the USA and we did see a bit of it when South Canterbury was allowed in to the Deposit Guarantee Scheme and to grow its balance sheet. Depositors could take money out of a bank and put it into South Canterbury at a higher interest rate without taking any more risk.
In a proper insurance based scheme deposit takers would pay a premium based on an insurers view of the risk. Lenders who were funding property developers would pay a premium which would theoretically reduce the interest rate they could pay to the same level as more conservative lenders. If we just have a government guarantee that variation in premium probably wont happen and it will create distortions.

"in that the existence of a deposit insurance scheme does lead to riskier behaviour by banks" states Toby Fiennes. Is that because the Banks are allowed or can pass the cost of the insurance on to their depositors? If they are prevented from passing the cost on, then it may be argued that they would be more likely t be more responsible in their behaviours as this will be a driver on the cost of the insurance.

 Deposit insurance will increase moral hazard, making the banks more susceptible to failure, which brings with it the need for more, costly regulation.
This is a total supposition - not backed by any analysis.  
The following is more likely, in my opinion.
 The OBR will increase moral hazard, making the banks more susceptible to failure, which brings with it the need for more, costly regulation.
If deposit insurance is such a danger - why do all other countries (excepting NZ and Israel) disagree?
 
EVERY insurance scheme has some unintended consequence - but NZ need not avoid what is commonplace in the rest of the world based on the recent failure of the RBNZ, Treasury and the government with their previously mismanaged deposit scheme.

@snippy .  If cost is $3 and selling price is $6 what you have is a 50% gross margin, not a 100% profit.  For a high overhead retail/service organisation like a bank, 50% is not a particularly spectacular gross margin.  Souvenir shops for instance typically have GMs of 70% or more.
It is possible to make 100% profit on something, as long as cost of goods is zero along with fixed and variable expenses.  

Not the sharpest tool are you snippy. $3 is what percentage of $6? 50%, right. 
Apparently you don't comprehend even basic business terminology. Suggest you learn the difference between mark-up, gross margin, and profit.
 You could start here, http://en.wikipedia.org/wiki/Gross_margin but I suspect it will go a little over your head.. Maybe there is something by Dr Suess......

Goes back to my origional point.
The $3 is only the gross progit / margin from which operting expenses etc have to be taken.
If I buy an apple for $3 and sell it for $6 the $3 doesn't all go in my pocket. There are costs which need to be taken out. I might get $1.50 in actual prot after these costs.
If you look ayt Banks total operations and cash flows there are far more profitable businesses out there: its just people focus on the numbers because they are big, not what they relate to.

I still like the idea of some form of insurance or guarantee for up to say $25,000 or even $50,000, to protect the mums and dads and retires. If they have more to deposit then they can spread it arround the banks. ( I think there are 14 of them currently)
Can I also get a second opinion on the following statement
Leman and fanny may both had a Fitch rating of A or better at the time of their collaps
Regards
Kevin

Kevin, the very same banks which operate in NZ must guarantee A$250,000 per depositor per bank in Austtralia, so not sure why they can't be required to do so in NZ.  It's entirely a decision by the RBNZ and their political masters.   
 
There has been no information given by the RBNZ as to what the cost is in Australia, but surely not beyond their capability to find out.   Likewise Canada and the US have $250,000 per depositor per bank.  Different situations, to be sure, but all other civilized countries in the world have deposit insurance except for NZ and Israel.    

Actually I think you fellow tax payers should also be guaranteeing my shonky finance comany investments, maybe my housing risk as well, and while we at it, maybe you should guarantee my share portfolio as well - us lazy investors need plenty of protection from ourselves by others
 
Of course the uninformed just consider an investment into a bank account as just an investment on which YOU take the investment risk on personally - shame on them, we all know the Govt is here to save us  

The problem with depositors having to assess the risk is that as has been pointed out, even the experts didn't see the current crisis coming. The bankers managered to camoflage what they were doing in complex packages that confounded even the most educated. this is about making bankers more accountable for their practices whilst not punishing the average depositor who has no or very little choice as to where they put their money. As has been identified in this discussion there is verly little to no competition in this country (or anywhere?) and people in general do not have a choice about using banks (don't agree? Try to get your wages paid in cash). the banks have managed to convince Goverments and business to go along with their model of business, but at the same time they clearly do not expect to be accountable for the risks they incur through their practices.  

To start with,  all investors should be assessing thier investments depositors are no different, clueless yes but they are grownups and should not be covered, that is moral hazard.
a) the likes of Steve Keen did see it coming, accurately.  Even Peter Schiff on the opposite side of the spectrum saw there was an issue even if he saw how it did or will pan out as differing to Steve Keen
b) Not just depositors got or will be burned.
You do have choices, you store your own cash or gold, or put it in a deposit box or short term govn bonds....if you are not up to that pay an advisor.  Then of course many ppl wont and whine when they get burned.   OAPs have been around 60 ~ 70 odd years more than enough time to figure out life is a bugger and they should take care.
Now I agree on the risks bankers take as being crazy, but frankly the same OAPs voted for the Pollies who have allowed this mess to start (in the 1980s) and carry on for 30~40 years.
Suck it up is my answer.
regards
 
 

Stevo , did you do the little quiz I left for you futher up the thread...? was interested in your response.

Suck it up is my answer.
 
I think you are right, all depositors should take out their money or at least demand that the poor who require mortgages to buy that home which they can only afford tomorrow forfeit it in favour of those lending them the money today.

While ignorance is no excuse in common law Stevo, allow me to put a little perspective on this for you, as I do see technically where you see this from.....but...
85% of Depositors will have never read a terms and conditions statement, with good reason, as they have not the skills to descipher what it is they are reading and would be further required to pay money to have it explained in ...plain english.
 Because the Bank is fully aware of this , should they not meet the plain english obligation to allow the customer the benifit of full disclosure.
 Ask as many people as you like (likely to hold TD's) , do they have investments, most that say no, when asked again well do you have any bank term deposits , will say yes.
theirs is not an undrestanding from the get go , that they have invested in something with  "risk" attached.......they really do think, oh well it's just in the Bank and they pay me a little interest and( tell me how great they are for having done so.)
Yes their is moral hazzard here, but equally on the part of the initial disclosure when a TD is placed....and what I see is for that obligation to be fullfilled in ...Plain English...with the deposit taker giving a brief aprisal of risk.

.

We don't need deposit insurance, because we all know as per the GFC, the government will introduce a scheme at the first sign of crises. Why have a well planned and thought out system when a hastily thrown together flawed system will suffice?

To those who think the government wouldn't step in, let me ask you, if NZ was facing a financial crises that looked like it would take down a couple of unnamed banks, would you choose to deposit your funds in a NZ bank, and gamble you wont face a haircut, or place them in an overseas bank that has a government backed deposit insurance scheme?