Deposit Insurance

Introduction

1. Over recent decades financial-sector regulation has developed in response to crises that called for effective failure resolution schemes. Although the causes of many financial crises are broadly straightforward to identify ex post, it is more complicated to construct effective pre-positioning arrangements ex ante.

2. A common failure resolution approach around the world is deposit insurance. A World Bank survey on bank supervision in 2007 showed that about 70 percent of high-income countries and half of upper middle-income countries have deposit insurance in place. The number of countries with deposit insurance or policyholder compensation schemes has increased significantly in the past 25 years. In most cases, however, deposit insurance has been adopted as the result of a financial crisis, as part of a broad financial-sector reform, or in conformity with European Union (EU) requirements.

3. The original driver for deposit insurance was to reduce the risk of bank runs or contagion risk within the financial sector. However, many legislators regard explicit depositor protection as a dominant reason for deposit insurance.

4. Among their developed country peers, New Zealand and Australia are the only countries that do not have deposit insurance. In recent times, the Australian Council of Financial Regulators has considered the potential implementation of a deposit insurance scheme. This initiative followed from the recent collapse of HIH and the International Monetary Fund’s Financial Sector Assessment Programme in Australia in 2006. The Reserve Bank of New Zealand (RBNZ) regularly reviews our policy stances, including on deposit insurance, and will do so in the light of possible reforms in Australia and the lessons from international events such as the Northern Rock experience in the United Kingdom.

5. This document discusses the RBNZ’s historical stance on the case for deposit insurance, including an evaluation of the extent to which deposit insurance could help the RBNZ meet the prudential policy objectives set out in Section 68 of the Reserve Bank of New Zealand Act 1989.

To what extent could deposit insurance help the RBNZ meet the prudential objectives?

6. The prudential policy objectives set out in Section 68 of the Reserve Bank of New Zealand Act are that our prudential powers are exercised for the purposes of:
   1. Promoting the maintenance of a sound and efficient financial system; or
   2. Avoiding significant damage to the financial system that could result from the failure of a registered bank.

7. Key issues in assessing whether or not a deposit insurance scheme would help meet our prudential objectives are:
   
   1. Lower contagion risk and lower risk of a bank run
      In general, deposit insurance can be expected to reduce the risk of a retail bank run. However, in general, banks’ liquidity pressures will also arise from wholesale funding, and a large proportion of New Zealand banks’ short-term funding is via corporate and other wholesale deposits. Deposit insurance will not apply to these sources of funding. For this reason, it is not certain that New Zealand deposit-takers would face significantly lower contagion risk, and lower risk of a bank run, as a result of deposit insurance.
      
      Evidence from other countries suggests that deposit insurance schemes tend not to be effective in preventing a retail bank run as they generally do not provide for immediate and full payout of deposits. This means that depositors still have an incentive to withdraw their funds in times of heightened uncertainty about the bank’s ability to pay.
      
      In addition to the above, the RBNZ notes that deposit insurance does not address many of the core failure-management issues such as access to transaction balances for all creditors and the completion of pipeline transactions in the payment systems.
      
      
   2. Depositor protection
      Deposit insurance might help promote depositor confidence, particularly in times of stress in the financial system, although typically the degree of depositor protection is limited as it applies only up to a predetermined level. On the other hand, the existence of deposit insurance may reduce the political pressure to ‘bail out’ a bank, could help take some of the political heat out of the management of an insolvent deposit-taker, freeing up the manager to work towards the best solution for the benefit of all relevant stakeholders .
      
      
   3. Sound risk management and governance practice in both bank and non-bank deposit-taking institutions
      Deposit insurance could weaken market discipline and exacerbate moral hazard risks. For example, a deposit insurance scheme could reduce the incentives for banks and other deposit-takers to enhance their internal risk management and governance practices. The more generous the scheme, the lower the incentives on depositors to purchase deposit products on the basis of safety and soundness, with the result that bank management will pay less attention to soundness issues and will have relatively more incentives to attract depositors on the basis of price and other factors.

8. While deposit insurance can introduce additional risk to the financial system, it is possible to reduce some of these risks through the design of the deposit insurance scheme. The following section discusses these risks, and how these risks can be mitigated.
   
   
   1. Weaker market discipline
      Deposit insurance can undermine market discipline in the financial system, and so reduce the incentives for sound risk management within banks and non-bank deposit-takers. On the other hand, a survivor-pays scheme could encourage deposit-takers to more closely monitor and exert discipline on one another, as might a form of co-insurance that exposes depositors to losses on a proportion of their insured deposits. Getting the balance right so that it does not provide an incentive to run on the bank is the challenge.
      
      
   2. Moral hazard risk
      Deposit insurance can exacerbate moral hazard risk by inducing more risk-taking by the insured deposit-taking institutions. There are several things that can help lessen moral hazard risk to some extent. Examples of these include effective supervisory arrangements, prompt corrective action for emerging stress situations, an ability to remove the senior management of a failed bank or non-bank deposit-taker, a risk-based approach to pricing deposit insurance, and the adoption of a low deposit insurance cap.
      
      
   3. Administration and compliance costs
      A deposit insurance scheme would incur administration and compliance costs. While the costs in a financial system with relatively few banks could be expected to be larger than in a system with many banks, these costs largely depend upon the structure of the insurance scheme and the role of the insurer. In particular an ex post funding scheme of a basic pay-box nature could be a straightforward and low-cost option compared to an ex ante joint funding scheme that might cause confusion around insurance cover and/or payout.
      
      
   4. More intrusive prudential supervision
      If the RBNZ introduces deposit insurance in New Zealand, it may be necessary to ensure that all insured institutions are subject to more intrusive prudential supervision to manage the risks associated with the deposit insurance scheme than otherwise. If insurance cover applies to banks and non-bank deposit-takers (such as building societies, credit unions, and the finance companies that fund via the retail debt markets), the deposit insurance scheme is likely to require a more hands-on approach to supervision than would otherwise be the case.
      
      
   5. A cross-subsidy to higher-risk deposit-takers
      Deposit insurance will be perceived as a subsidy on higher-risk banks and other deposit-takers, especially if the scheme charges a fixed ex ante fee or if the surviving insured institutions fund the scheme on an ex post basis. This potentially causes distortions in the financial sector. A risk-based insurance fee can help level the playing field for the insured entities, though it is very hard to calibrate in practice.
      
      
   6. Viability of a deposit insurance scheme in a small financial system
      It may be more difficult for deposit insurance schemes to cover losses arising from a large bank failure in a small highly concentrated financial system. Any shortfall might need to be shared between the government or contributions from the surviving entities.

9. The above issues are matters that the RBNZ had taken into account in the past when it reached the view that deposit insurance was not appropriate for New Zealand at the time.
   That said, the RBNZ continues to monitor both developments abroad and domestically, and the implications that these developments may have for the case for deposit insurance in New Zealand.