If the Reserve Bank's approach is adopted to implementing the Deposit Takers Act that Parliament finally passed into law in July, we're likely to see some of the smaller institutions close their doors while others will be doomed to be less profitable.
The central bank and prudential regulator is making it plain as day.
“Some deposit takers may need to modify their business model to meet the minimum standards. Others may need to assess their viability in line with operating in a well-regulated competitive marketplace,” RBNZ says in one of several discussion documents out for consultation.
But the real stingers are in another paper on how to structure levies paid by these regulated banks, building societies, finance companies and credit unions to finance the Depositor Compensation Scheme (DCS).
The scheme will mean that deposits up to $100,000 will be insured – while individual banks will need to upgrade their systems so they know the aggregate amount each depositor has, an individual depositor wanting to protect more than $100,000 can do so by lodging deposits up to that amount with different banks.
RBNZ has come kicking and screaming to the concept of deposit insurance, having long proclaimed that it would create a “moral hazard” and favouring what it calls “open bank resolution” (OBR) instead.
Moral hazard
In a speech earlier this month, RBNZ's director of enforcement and resolution, Kerry Beaumont explained the “moral hazard” theory.
NZ's previous light-handed regulatory approach, in large part relying on disclosure and market discipline to regulate banks, “was designed to provide depositors with a strong incentive to monitor the financial strength of their bank and force riskier banks to pay more for their funding, thus incentivising them to act more prudently,” Beaumont said.
But very few bank depositors would have the knowledge or skill to do anything of the sort. Indeed, there's a prevalent belief in the community that the government has always guaranteed bank deposits.
In truth, we've only had any kind of actual government guarantee previously between October 2008 and October 2010 when the government was forced to act during the wholesale collapse of finance companies – retail depositors in nine companies ended up drawing on the scheme.
I became convinced some time ago that OBR simply wouldn't work and that no government would allow any of the major banks to fail, and likely would respond to protect depositors in any smaller bank that failed too.
I'm in good company since even the Treasury doesn't think OBR would work as intended.
Depositors would pay
OBR would mean that once a failing bank's equity is exhausted, RBNZ would determine a “de minimus,” or very small amount of each deposit, be released to each depositor while it worked out how much of that bank's losses every depositor would be required to cover.
Treasury said in a June 2019 paper that OBR wouldn't work as intended, thus agreeing with a wide number of other experts who have panned the idea, including the New Zealand Bankers Association which noted there are no examples in the world of OBR working.
Anyway, after an unfavourable International Monetary Fund (IMF) report in 2017, RBNZ ended up losing the argument.
Among the IMF's recommendations was that New Zealand needs a deposit insurance scheme and so at last we're getting one.
However, RBNZ hasn't abandoned its “moral hazard” arguments in its proposals on how much to charge each institution in premiums to finance the scheme.
It is suggesting all deposit-taking institutions be divided into four separate “buckets”, possibly based on their credit ratings or a type of “composite risk indicator” that would take into account factors including how much capital they have, liquidity, asset quality and profitability to award each institution a score.
A quadrupled fee
The idea is that the institutions in bucket four would pay four times the levy on a per-deposit basis than those in bucket one would pay.
Banking professor at Massey University David Tripe has no doubt what the result of that would be: “You will end up conferring a massive benefit on the four major banks.”
Tripe points out the irony of a government-mandated inquiry into supposedly “excessive” bank profits being conducted by the Commerce Commision at exactly the same time as RBNZ is promising to confer yet another benefit on major banks.
(It's a story for another time, but RBNZ has been shovelling cheap money at the major banks for several years, making the question of why they're so profitable asinine.)
RBNZ's own workings illustrate that this would be the outcome, even though it didn't name the banks and other institutions.
Using credit ratings, two of the banks would end up paying a levy larger than 5% of their profits, and no prizes for guessing they would among the smaller banks.
Anybody who's spent even a cursory amount of time looking at credit ratings knows that the bigger the outfit is, the more likely it is to have a higher credit rating. Size definitely matters.
Bigger toll on smaller banks
RBNZ notes the pattern of the last decade has been that “big banks have relatively stable profit performance while small banks and non-bank deposit takers (NBDTs) have a more mixed performance.”
The levy, whether based on credit ratings, a composite indicator, or even a flat levy per amount of deposits covered, would have a minimal impact on two of the banks and only a small impact on another six banks.
But on NBDTs, the credit rating approach would have “a significant adverse impact” while “for 60% of NBDTs, using a composite risk indicator appears to lead to levies that are less than 10% of annual profits,” RBNZ says.
I'm not sure many companies would consider a levy of 10% of their profits as being small.
“However, a number of other firms have low profits or recent losses so levies will be more material to their profitability outlook.” To be clear, that's 40% of non-bank deposit takers.
There's already a wide gap in the costs burden between the major banks and their smaller counterparts – as Heartland Group noted last month, its cost-to-income ratio in the year ended June was 42%, but the CTIs of other small NZ banks are closer to 60% to 80%.
Where the majors stand
By comparison, Tripe has calculated Westpac's CTI in the June quarter was 44.15%, ASB's was 40.36%, BNZ's was 35.37% and ANZ's was 32.43%.
On top of the financial impost of the levy, RBNZ is promising the new prudential regulatory regime set by the Act, which is set to come into force by 2024, “will not represent an overall lowering of prudential standards.”
And actually, “in some cases, requirements will be strengthened under the Act relative to the status quo.” So, expect more regulatory intrusion.
“This reflects the overall shift to a more intensive regulatory and supervisory regime in NZ, which has been underway since the IMF's financial sector assessment program report in 2017. It also reflects the forthcoming introduction of the DCS, which socialises the cost of entity failures.”
That's an interesting way to describe an insurance scheme that the financial institutions themselves are going to be required to fund.
And RBNZ harps back to that “moral hazard” theme again.
“Depositors (if they are fully covered under the DCS coverage limit) would have little incentive to monitor the performance of deposit takers,” it says.
“As a result, funds may flow to weak institutions for high-risk ventures at lower cost. Unless effective steps are taken, the deposit insurance system may face the possibility of increased losses and the economy as a whole may suffer as a result.”
Bury this fiction
I'd suggest it's way past time for RBNZ to bury the fiction that the average depositor, or indeed even some very sophisticated depositors, are in any way capable of “monitoring the performance” of the banks that hold their deposits.
People deposit money in banks because they believe banks are safe places to put their money.
They expect somebody more qualified to do the “monitoring,” such as RBNZ, the actual regulator.
The assumptions about the DCS both RBNZ and Treasury are using is that it should have a targeted size of 0.8% of protected deposits and take about 15 years to reach that target.
The levies collected would be deposited in high-quality liquid assets, such as government bonds, and could be expected to achieve a 3% annual return. Interestingly, the government intends to tax these earnings at the usual 28% company tax rate.
Given that the government will in all likelihood still be on the hook for any losses over and above the DCS, you might say taxing the fund is fair enough.
Submissions on these consultation documents close next Monday, Sept 25.
Some economists in RBNZ seem to like late 1980s debates, making NZ 30 years late on deposit insurance. The moral hazard argument also seems backward compared to the rest of the world, where big banks/SIFIs are asked to pay more because they present a much larger systemic (aka too big to fail) risk.
Great article Jenny, keep up the great analysis.