Opinion: BNZ warns of dangers in deposit guarantee scheme

By BNZ Markets' Stephen Toplis The bothersome thing about any government intervention into market processes is that there are almost always unintended consequences. In this regard, recently announced plans by government to offer deposit insurance to retail depositors take the cake. We should say up front that, in theory, we are opposed to deposit insurance schemes of any shape or form because they encourage an inappropriate use of capital. Depositors need to assess risk and act accordingly. Moreover, investors who put money into risky assets should be compensated appropriately for doing so. Indeed, the primary source of the problems that we now face was that the relationship between risk and return broke down, allowing investors to put money into assets with scant regard for the possibility that they might not get it back. Having said this, theory and practice become quite different things in the current environment. Importantly, if there is a shortage of funds available and risk is perceived as high, then investors will naturally put their money where the risks are seen as low. With this is in mind, government guaranteed jurisdictions will much more easily acquire funding than those which are not. So if you don't join the pack, you could end up in trouble. It was with this in mind that the domestic guarantee was instituted. Accelerating this process was the growing anecdotal evidence that retail depositors in the New Zealand banking sector were growing anxious and removing funds. We would argue that this concern was misplaced, but when folk are as worried as they currently are, one can't blame them for doing what they think is necessary to protect their precious savings. Given this, it was entirely appropriate for government to act as a circuit breaker and it did. While we recognise the government might have felt the need to do something and do it quickly, and that what it has done is a reasonable stop-gap measure, we are equally concerned that more work needs to be done. At this stage, we are giving the authorities the benefit of the doubt and are assuming that what we have seen so far is work in progress but caution that to sit on their hands now might prove problematic. This is where the unintended consequences come into being. First up are the potential problems associated with the deposit insurance scheme itself. In the first instance, we are keen to see details as to which banks and non-bank financial institutions the Reserve Bank will agree to insure. Whatever the case, there will be problems. If it is decided that almost all and sundry are insurable then this is likely to result in an inappropriate allocation of capital. From an investor's perspective there will be no difference in risk between putting money with a high risk lender, which highly leverages its funding base, against a low risk, lowly leveraged lender. This being so, if the higher risk lender is willing to offer a slightly higher return than its lower risk companion then money will be channelled into these areas. This is actually the very problem that started all this mess. Alternatively, if the authorities adopt a much tougher line with respect to who they will insure, this will potentially kill off those organisations who do not meet the necessary standards as they will struggle to get depositor funding. An interesting corollary to this process is that institutions have to pay for their funds to be government guaranteed. That seems entirely appropriate. After all, insurance of any type comes with a cost. But what makes this particular scheme unusual is that you don't pay any more for being a high risk lender. In fact, quite the opposite, if you have a small deposit base (less than NZ$5.0 billion) you pay nothing. If (and this still a big if), the RBNZ agrees to insure some of the smaller non-banklenders then this would surely send all the wrong signals. At the extreme it would be a bit like a health insurer charging you more for being fit and healthy than it would if you were sedentary and a heavy smoker. We accept that no deposit insurance scheme will be perfect but reckon there's still room, and time, for a bit of fine tuning here. While there are issues around the retail funding guarantees, the bigger immediate concern we have is with the lack of wholesale funding guarantees. For many in the banking sector it means that the recent regulatory changes have made matters more, not less difficult. Roughly speaking, the core banking sector raises around 40% of its funds from wholesale markets. Of this, a substantial proportion was raised from offshore. With offshore markets in disarray this funding opportunity has largely dried up for the time being, but banks were still able to raise cash from the domestic institutional investor base. Now, however, those institutions, cognisant of providing the best risk/return mix for their own investor base, are querying whether they should throw their money at the New Zealand banking sector or the now-government-guaranteed institutions offshore. This has become particularly pertinent given that the Australian government has also guaranteed its wholesale funding base. Because of this, it's now the entire wholesale funding base of thebanking system that is being compromised not just theoverseas component of it. Moreover, in the event that offshore funding pressures do ease up, as one would hope given the global rescue measures in place, then New Zealand would not be an early recipient of those enhanced funds flows because of its lack of guarantee. There are some who argue that the recapitalisation measures taken elsewhere and the regulatory changes adopted in Australia mean that domestic banks can simply go to their Australian parents for more money. There is some truth in this. However, Australian regulations also state that their core banks can only allocate so much capital to their New Zealand offshoots. This being so, the pot of gold that they can provide has only a limited ability to appease domestic liquidity constraints. Consequently, after a period of time, the same old insurance problem rears its head again. We note that the pressures that we are highlighting here are of extreme importance for the health and well being of the New Zealand economy. They are not risks that the average depositor need worry about but where they hit home is the broader real economy. If banks can't get sufficient funding they can't lend as much. This curtails investment activity, in particular, and wider economic growth in general. This is far from ideal.  While the above addresses the key issues that the banking sector currently faces and the unintended circumstances that have evolved over the last couple of days, we also note two other issues that have cometo the fore. To start with, Treasury was forced on Tuesday to announce that it would postpone its upcoming bond tender. The reason given was the markets are too volatile. Read this as bond yields unexpectedly pushed higher, following the announcement of the insurance scheme, as local investors returned to the banking sector from the "safer" government securities. Had the volatility pushed yields lower, we suspect no such postponement would have occurred. And last but not least, here's hoping that this whole rescue process, both here and offshore, does not result in the household sector going back to its over-spending ways. After all, we desperately need a correction to household sector balance sheets. This is particularly so in current account deficit countries such as our own, as households need to increase savings if national savings ratios are not to be pole-axed by the current run down in government saving. So it's now watch and wait. And we are quick to point out that it's watch and wait for the Government not so much the Reserve Bank. While it is the Reserve Bank that implements regulation and advises the politicians, it is government that makes the rules and writes the cheques. By and large, we believe the authorities here are moving in the right direction to ensure that the New Zealand economy rides the global financial morass as successfully as can be hoped. We simply hope that they don't think they have now finished what they need to do and we plead that all involved in this process put politics aside for the time being and just get on with the job.  *This Economy Watch Report was written by BNZ Markets' Stephen Toplis. All of the research from the BNZ Markets team of economists is available here.