There has been an astonishing amount of alarmist comment – certainly in the “New Zealand Herald” and even on Radio New Zealand – about the possibility that the Reserve Bank of New Zealand could impose a “Cypriot-type” tax on bank deposits in the event of a bank failure. People have expressed outrage at the idea, and Russel Norman has suggested that a deposit insurance scheme would be a “much simpler, well-tested alternative” to what the RB is proposing, formally called Open Bank Resolution (OBR).
But while a deposit insurance scheme may or may not make sense (there are some significant negatives about any such scheme), it would not deal at all with the problem which OBR is designed to deal with, namely the failure of a large bank.
Fortunately, New Zealand’s banks are in very good shape.
But IF a large bank got into trouble, there aren’t many options. Central bankers used to contend that no bank was “too big to fail”. They say that with less conviction these days.
The reality is that while no bank is too big to fail, some banks are too big to close. Why? It’s not just that very large banks hold a huge portfolio of loans which keep the economy ticking over, and a huge volume of deposits, but mainly that all banks are closely linked through the electronic payments system. Pull one of the major components of that payments system out and the whole system stops. The damage which would be done to the whole economy would be absolutely massive.
But if we rule out closing a very large bank, what options are left? The best option, of course, would be for another bank to take over the failing bank. But that would almost certainly be very difficult to arrange in a very short time – probably over a weekend. There would be huge uncertainty about the value of the bank – which could in fact be substantially negative. In those circumstances, even the largest banks would hesitate.
Another option would be for the government to step in and use taxpayers’ money to recapitalise the bank by buying new shares in the bank (as the British Government did for several of the failing banks in the UK during the Global Financial Crisis) or guaranteeing the liabilities of the bank (as the Irish Government did for several of the failing banks in Ireland).
But, as several governments have found to their cost, any government bail-out of a systemically-important bank comes with an enormous price tag. Ireland’s government debt was quite modest before the Global Financial Crisis – just 25% of Irish GDP in 2007 (not unlike New Zealand’s government debt at the moment). Today, it is over 100%, and the cost of bailing out Irish banks was the biggest single factor in that increase.
Moreover, there is another, indirect but perhaps even more important, cost of having the government bail out the banks. The prospect of a government bail-out allows large banks to trade on implicit government backing – they make the profits and the big executive bonuses if things go well and taxpayers pick up the tab if they don’t. This can only encourage risky behaviour.
So more for than a decade the Reserve Bank has been working on how a distressed bank could be failed without being closed. As I understand current thinking, if a systemically important bank were to get into serious trouble, its shareholders would lose all their money, its board and senior management would get fired, and bank creditors (including depositors) would have a small proportion of the money owed to them by the bank frozen – but with the bank continuing to operate under statutory management.
How much of a depositor’s money would be frozen? That would depend, of course, on how much of a mess the bank was in but 10% is a plausible figure. The figure would have to reflect the likely size of losses in the bank. In other words, after the “freezing” the aim would be to ensure that the “unfrozen” deposits matched the loss-depleted assets of the bank.
It is almost inevitable that, if this situation ever actually happened, the government would need to guarantee other deposits in that bank, and potentially in all banks for a time – to avoid a bank run on the remaining deposits and on other banks.
Is the mandatory freezing of a proportion of people’s deposits a desirable situation? Of course not. It’s quite undesirable. But if a very large bank were in danger of folding, there are no attractive options, only a choice between unattractive options. If the bank were to be allowed to close, depositors would certainly lose a considerable portion of their deposits, and the damage done to the whole economy would be enormous. If the government were to bail out the bank, there would be a big increase in government debt, and potentially a big increase in taxation (or reduction in government spending) as a result. There simply are no painless options.
What is important is that banks cannot trade on the assumption that the government will bail them out if they make risky decisions, and that the costs of failure rest where they should – first and foremost on bank shareholders and their directors and senior managers, and secondly on those who chose to lend them money.
It’s worth remembering that, apart from the short period during which the government guaranteed all banks, finance companies and credit unions during the Global Financial Crisis, and the extended period during which the government guaranteed all the trustee savings banks (until 1988), banks have never been guaranteed by the government in New Zealand. That’s one reason why the Reserve Bank requires all banks to make available easy-to-understand and up-to-date financial information on their operations.