Editorial: Banks lose comfort of being 'too big to fail'

Everybody with money in a bank in this country will be alarmed at first reading of the Reserve Bank's plan to seize some depositors' funds in the event of its failure. Events in Cyprus - where eurozone ministers are forcing Cypriot savers to share the cost of the country's bailout - have been a reminder that money in banks is not sacrosanct, no matter what depositors believe.

What depositors believe, with good reason, is that banks are too big to fail and that governments will always come to their rescue. The global financial crisis reinforced that impression almost everywhere. Even here, where the major banks remained sound, the Government hurriedly installed a deposit guarantee scheme to remove any risk to the system.

In the wake of the crisis, banking regulators in many countries have been worrying about comfort they have given to financial institutions. Banks that know they are "too big to fail" may drift back into the reckless and careless behaviour that contributed to the crisis. New Zealand's regulator, the Reserve Bank, is proposing a novel answer.

Its policy would mean no bank is too big to fail but with depositors' funds it could be quickly recapitalised. Insolvency would be met with an "open bank resolution" by the Minister of Finance that would give a statutory manager power to confiscate enough from the bank's deposits to cover its liabilities. To avoid a run on remaining deposits the Government would probably guarantee them and, all going to plan, the bank could reopen on the next trading day.

Its shareholders' funds would be wiped out, as in any company failure, and depositors with more than a small amount in the bank, possibly $20,000, would take a "haircut". Their loss might be converted to shares in the rehabilitated bank, though that would be cold comfort to people who do not think of bank deposits as an investment in the institution, even while it is paying them interest and using their funds.

The great benefit of this idea is that depositors would start acting like investors. Just like investors in other companies, they might know nothing of a bank's business but they would be alert to commentaries and criticism of its performance. More important, the bank would know its savers are now alert to any criticism and it would take extra care to avoid it. That is the benefit depositors' liability would bring to the economy as a whole.

The benefit would be gained without any account holder taking a haircut. If banks became more cautious they would be even less likely than now to behave in a way that risks an open bank resolution.

The risk that depositors would face in the event of failure would make their deposits safer than they are in the absence of a guarantee from taxpayers.

The Government removed the guarantee as soon as it could after the crisis, but not before it had to pay out nearly $1.8 billion to depositors in South Canterbury Finance. The scale of that single call on the scheme by a non-banking institution shows how crippling it could be for the Government to insure a bank's deposits. The banks could insure depositors themselves but find it too expensive.

If a bank were to fail, the pain of personal savers would cause an outcry many times louder than any heard from finance company investors five or six years ago. That is the reason banks have enjoyed an "implicit" guarantee. This proposal would remove it.

Banks would know that none of them are too big to fail, and their depositors would be watching.