David Mayes: Government must insure our savings

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New Zealand lagging behind in scheme to protect deposits, which could be funded by banking industry.

At any hint of trouble at their bank, most people's only option would be to withdraw their funds. Photo / Thinkstock
At any hint of trouble at their bank, most people's only option would be to withdraw their funds. Photo / Thinkstock

All advanced countries except New Zealand offer protection for ordinary depositors of up to $300,000 a deposit in each financial institution. Australia has it, many emerging economies offer smaller sums where income levels are lower, and international authorities in Basel are encouraging all countries to adopt it.

So if you had a million dollars, you could spread it over four banks and be fully protected. Here in New Zealand, however, not only is there no such insurance, but the Open Bank Resolution scheme - which the Reserve Bank is putting in place - makes it virtually certain that depositors will suffer losses if their bank fails.

Of course we have strong, well-managed banks here that are supervised by the Reserve Bank, so the chance of any failure is very slim. But the global financial crisis has seen some of the largest and best known banks globally fail, and others have encountered severe difficulties.

Other countries think that ordinary deposits should be protected for three main reasons. First, most people do not have the resources or ability to find out if their bank is drifting into trouble, and will be at the end of the queue for getting any money back.

Secondly, ordinary people cannot afford losses in the same way as wealthier investors. Typically their bank account is their only source of financial wealth, except any pension funds. The Reserve Bank says it may exclude small deposits from making losses, say up to the first $20,000 and, while that is better than nothing, it means all the other depositors have to cover that cost and get even less back.

Thirdly, deposit protection aids stability of the financial system. If they hear rumours of bank difficulties, all depositors' sensible course of action is to withdraw their money. Since our main banks are so big, the chances are that if one bank is in trouble, the whole banking system will be in difficulty because of the interrelated nature of the banks and their common risks.

In troubled times interest rates are normally low so the loss from having cash or investing in some other safe asset will be small. The Open Bank Resolution system will thus encourage instability in difficult times and, most importantly, give the authorities less time to sort out any bank problems. Given all the above, it would seem painfully obvious that we ought to have depositor protection. The Australians go one step further and have domestic depositor preference, so their depositors rank above the other unsecured creditors.

Obviously there must be something that puts New Zealand authorities off. One concern is moral hazard - having less at stake means banks may take more risks in their pursuit of profit - and another is the understandable concern that taxpayers should not pay for banking failures.

Depositor protection, however, need not be paid by taxpayers. Most systems are financed by the banks up front, and European countries are setting up special industry-funded resolution funds beyond deposit insurance to ensure that taxpayers do not get caught out.

The worst side of having no explicit deposit protection is that during a crisis, the chances are authorities will rush in with a temporary scheme (just as they did in 2008) which will be taxpayer-financed and colossally expensive. The government will fear the instability of a depositor run and the electoral consequences of imposing losses on a large portion of society, but temporary schemes are less equitable in imposing losses on those who deliberately took risks.

The banks argue, incorrectly, that such funded schemes will be too expensive. But unused funds remain on the balance sheet, earning a rate of return like other assets. Management costs are minimal - the Finnish insurance fund has just one part-time employee.

There is thus little cost in good times from having depositor protection and little adverse effect on how banks manage their risk, but a major benefit to ordinary people should anything go wrong.

It is very difficult to think of any reason why New Zealand should not join the rest of the developed world in having an industry-financed scheme, which should be phased in slowly now, while banks are strong, so that if we are unlucky enough to have another crisis, we are all well prepared. Of course, it may well be that all the other countries are wrong.

In all other respects the Open Bank Resolution is an excellent scheme and well ahead of other countries'. Bank difficulties can be quickly resolved without depositors losing access to their funds and without the taxpayer having to part with a cent.

The Reserve Bank is to be congratulated on its early action to avoid the harsh consequences of large bank failures. But without deposit insurance it just won't work.

David Mayes is Professor of Banking and Financial Institutions at the University of Auckland Business School.

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