Reserve Judgment

In the unlikely event of a bank collapse, a proposed new measure would help safeguard our savings.

Listener: 27 April, 2013

Keywords: Macroeconomics & Money;

Banks can fail. That is not the same as a run on a bank, in which depositors withdraw funds faster than the bank can liquidate its investments, even though it has a sound balance sheet. The Reserve Bank routinely steps in as lender of last resort when banks can’t keep pace with withdrawals, a situation that went largely unremarked as bank liquidity tightened in September 2008 when the global financial crisis began.

A bank failure, however, is more permanent. Normally a bank will have more assets – loans, mortgages, trade advances, bonds and government stock – than deposits. The surplus is the equity owned by the shareholders. If the bank’s assets are worth less than the deposits, there is nothing for the shareholders and the bank cannot pay all its depositors.

The term “bank” in the last paragraph can be replaced by “finance company” (or credit union) and the analysis is exactly the same. When a finance company fails, its depositors lose the value of some or all of their investments. That is tough but they took a higher interest return in exchange for the risk of their investment failing.

Banks, though, are the foundation of our payments system. If they collapse, the economy could seize up because nobody could pay their bills or buy anything. Businesses without trade credit might have to lay off workers. Thus a trading bank cannot be left to collapse in the way a finance company or other business can.

There are a number of measures to protect the payments system, including the Reserve Bank’s role as lender of last resort to sound banks. Additionally, its six-monthly financial stability reports give investors information on which to base their decisions. The Basel-based Bank of International Settlements, meanwhile, has been setting higher standards for equity so there is greater protection for depositors if a bank’s investments go awry.

Last month, the Reserve Bank announced a proposed “open bank resolution” policy, or OBR, for when all else fails and a bank (or number of banks) collapses. Under our banking system, such a failure is unlikely: although other financial institutions have gone belly-up, there has been no severe trading bank problem in the past two decades.

Even so, the Reserve Bank considers it needs further protection. The OBR would work – roughly – like this. At present, if a bank gets into trouble, the ordinary liquidation processes for any troubled business will be triggered and the bank will close. However, the OBR would enable a troubled bank to open the following day, although depositors would be limited to accessing, say, 90% of their deposits, with a government guarantee so they do not have to rush to remove their funds.

The remaining deposits would, however, be frozen and used to cover losses on the bank’s assets if they exceeded shareholder funds. In that case, depositors wouldn’t get all the rest of their money back (although they would probably get some).

We should welcome the proposed OBR, for it clarifies what would happen in the unlikely event of a bank collapse. Admittedly, the Reserve Bank announcement has caused some shock because it explicitly draws the possibility of bank failure to our attention. And without an existing government deposit guarantee, a bank collapse would mean individuals could lose out.

The present Government has ruled out an insurance scheme that would guarantee depositors’ investments. Such insurance is not a substitute for the mechanism proposed by the OBR, in any case.

But maybe what many New Zealanders would like is both, accepting a high level of deposit security in exchange for a lower return on their deposits. The Reserve Bank’s OBR proposal does not exclude a future government introducing deposit insurance.

I wouldn’t be surprised if that happens one day, although taxpayer exposure is likely to be limited. Whether you put your money in a bank or under your mattress, there are no guarantees. Life is risky.