Deposit insurance expert suggests $100k cap will need to be increased over time to maintain inflation-adjusted value

Geof Mortlock, a New Zealand expert in deposit insurance, is disappointed the incoming NZ scheme won't include depositor preference, says it will need to lift the $100,000 depositor payout cap over time to match inflation, and supports the fact it's not being designed to fund systemic bank failure.

As recently reported by interest.co.nz, Treasury and the Reserve Bank (RBNZ) are consulting on the size of the fund that'll be established to back the deposit insurance scheme, suggesting it could be equivalent to 0.5% to 1.1% of protected deposits, or $600 million to $1.4 billion.

The cost of the depositor compensation scheme (DCS) will be funded by levies on all licensed deposit takers, that will be held in a DCS fund. Treasury proposes a timeframe for building the DCS fund of between 10 and 20 years. Levies during the fund build-up phase will reduce deposit taker profits by an annual average of between 0.6% to 2.4%, Treasury estimates, if the full cost is borne by deposit takers, or reduce deposit rates by between four and 15 basis points, if the full cost is borne by protected depositors.

The DCS will be established by the Deposit Takers Act to cover bank depositors in the event of bank, or non-bank deposit taker such as a building society, failing. Depositors will be covered up to $100,000 per depositor per licensed deposit taker. The DCS is expected to commence in late 2024.

Mortlock, who spoke about deposit insurance in an episode of interest.co.nz's Of Interest podcast last year, says he doesn't support the Government's decision to not adopt depositor preference. Under depositor preference depositors rank ahead of other secured creditors in a liquidation.

"I think it was a poorly conceived decision and that the RBNZ gave inadequate advice to the Government on the matter. Depositor preference is becoming increasingly common globally and has long been a feature in Australia and the United States. It helps to lower the risk of depositor runs and lowers the costs to the deposit insurance scheme, and therefore levies," says Mortlock.

"Deposit preference should be reconsidered."

Mortlock is an international financial regulatory consultant who undertakes work for the International Monetary Fund (IMF) and World Bank, specialising in financial system stability, resolution of bank failures, deposit insurance and related matters. 

Depositor preference also makes bail-in more feasible and lowers the cost of compensation payable by the Government, or a resolution fund, under the 'no creditor worse off' principle if bail-in is used and applied only to bonds issued by banks and possibly to wholesale deposits, he adds.

Statutory bail-in is a resolution tool where unsecured liabilities may be written down or converted into equity. Bank liabilities typically include deposits and bonds. The idea is the costs of a deposit taker’s failure would therefore fall on its investors and creditors rather than the public purse. Bail-in powers are designed to help authorities recapitalise failing financial institutions quickly, helping restore viability and capital ratios above regulatory minimums.

The potential for bail-in standards is included in the Deposit Takers Act. This is even though it emerged last year that the Government had decided not to give the RBNZ statutory bail-in powers.

How would systemic bank failure be funded?

Mortlock points out Treasury and the RBNZ's approach makes the explicit assumption that the scheme wouldn't be used to fund a systemic bank resolution. However, he says it could be used to make a least-cost contribution to such a resolution, subject to ensuring the scheme has enough money left to meet depositor reimbursement for small deposit-takers. 

"This approach accords with my own view and with the advice that I and my IMF and World Bank colleagues give when advising governments globally on the design of deposit insurance schemes. I.E. the target level should not be set on an assumption that the scheme would be the primary funding source for systemic bank resolution, but rather, should be based on the funding costs associated with resolution of small to medium-sized deposit-takers."

"I therefore support the approach being taken in that regard. That said, it does then raise the issue of how a systemic bank failure would be financed. Bail-in could be used to absorb some losses, but bail-in is only likely to be feasible to the extent it is applied to subordinated and then senior bonds/paper issued by banks. It is unlikely to be a feasible option if extended to large-value deposits, I.E. the poorly conceived 'open bank resolution' arrangement applied to major banks by the RBNZ, which involves 'haircuts' to large-value deposits," says Mortlock.

"Applying a haircut to deposits is a recipe for triggering a pre-emptive run on a bank and thereby exacerbating its situation and most likely causing a contagious run on other banks."

He describes the RBNZ's existing Open Bank Resolution (OBR) bank failure tool as "ill-conceived, unlikely to be practicable and potentially dangerous."

"What is missing therefore is a funding framework for systemic bank resolution - including a required tranche of bail-in debt, coupled with either a pre-funded systemic bank resolution scheme financed by levies on systemic banks, which is what European Union member countries have, or a post-funded resolution funding arrangement, in which legislation empowers the funding of a resolution by the government with scope for ex-post levies on systemic banks to recoup losses. I am not sure whether the Treasury has given this much thought, but it is an issue that warrants further consideration," says Mortlock.

"I would favour a post-funded model rather than building up a pre-funded systemic resolution fund."

The Reserve Bank says it will review its OBR policy once the planned depositor compensation scheme is rolled out  OBR is a tool that could be used if a bank failed, as an alternative to a liquidation or a bailout funded with public money, that would keep a bank open for business. There's a detailed explanation on how OBR could work here.

What about inflation adjustment?

Meanwhile Mortlock questions whether the calculations of the target size of the DCS take into account the need to progressively increase the $100,000 deposit insurance cap over time to maintain its real inflation-adjusted value.

"The deposit insurance cap is already at the low end of a plausible range for a deposit insurance scheme - considerably lower than in the European Union, United Kingdom, United States and Australia. Over time, its value will be eroded by inflation and by reference to the growth in average deposit balances. The arrangements should therefore factor in the need to increase the deposit insurance cap every few years, e.g. every five years, to maintain its real value. The target size of the fund would therefore need to increase to reflect this," says Mortlock.

He says the target size of the DCS fund needs to be big enough to meet deposit payouts for protected accounts for at least several small deposit-takers, such as where three or four small deposit-takers fail within a short timeframe, and ideally sufficient to meet payout obligations for several small deposit-takers plus a medium-sized deposit-taker.

"I assume that the RBNZ/Treasury have modelled the target size of the fund taking into account estimated medium to longer term probability of failure and loss given failure on the basis of a range of stress test scenarios and that the fund size has been estimated using this modelling and is sufficient to meet depositor reimbursement for multiple small deposit-takers and a medium-sized deposit-taker. The paper does not get into a lot of detail on this, but does provide some data that is helpful. My hope is that the model they have used and the scenario assumptions that have been made have been subject to appropriate independent assessment to ensure that the model parameters and assumptions are robust. That should certainly occur if it has not already been done," Mortlock says.

He also notes that Treasury discusses risk-based versus uniform levies, but doesn't appear to come to a firm conclusion.

"My view is that it would be better to go with risk-based levies so that higher-risk deposit-takers pay a greater amount in basis points per dollar of deposit than lower-risk deposit-takers. This would strengthen the incentives for sound risk management practices and reduce the degree of cross-subsidisation of higher-risk banks by lower-risk banks. I would therefore favour the adoption of a risk-based levy that is based on either credit ratings or a composite risk rating applied by the RBNZ, despite the risk of adverse signalling. An increasing proportion of deposit insurance schemes around the world are risk-based for these reasons."

Although there have been no bank failures in NZ in recent years, there have been banking crises in the past, and much of the finance company sector dissolved between 2006 and 2012.

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