A crisis of confidence
Governments around the globe have responded to extreme volatility in financial markets by creating new benchmarks for depositor insurance. Failure to follow suit could have disastrous implications.
When the Irish Government decided to guarantee all bank deposits last week it set in motion irresistible pressures on other European governments to follow suit. The German government emulated the Irish at the weekend and Britain's deposit insurance coverage will rise sharply tomorrow.
While all European governments have some form of deposit insurance (it is required by the European Union) the Irish move, which guarantees about $A750 billion of bank liabilities, set a new benchmark and reportedly triggered a flow of deposits out of UK banks into the UK branches of Irish institutions.
The fear of guarantee-inspired diversions of liquidity no doubt played a role in the British Government's decision to increase its insurance coverage from £35,000 to £50,000. It has also caused other European countries, including France, to publicly ponder following the Irish. The Americans have already lifted their deposit insurance coverage from $US100,000 to $US250,000 to try to bolster confidence in their institutions and prevent further liquidity crises.
A failure to respond to the bidding up of depositor protection levels, apart from the potential for a flow of deposits from banks with lesser guarantees, might also be interpreted by depositors as a lack of confidence by government in their own system – or a lack of capacity or will to protect depositors.
The Irish decision has been criticised by other European governments, who presumably are concerned about security-driven runs on their institutions if they don't respond. It is also being investigated by the European Union on competition policy grounds.
Australia has traditionally been unconvinced about the merits of deposit insurance. It has stood out among the developed countries as the only rich country not to provide some level of insurance. That is about to change.
After more than a decade and a half of debate dating back to the recession of the early 1990s, which saw the collapse of the Pyramid Building Society and massive losses by the major banks, the Rudd Government announced in June that it would introduce a depositor protection scheme, insuring the first $20,000 of deposits in authorised deposit-taking institutions.
The $20,000, incidentally, doesn't appear to be specified in the legislation but was the level at which the scheme was expected to start. The government said when announcing its plans that it would review them against international arrangements for deposit protection once the international arrangements were settled. Given what is happening overseas, the government might have to reconsider the opening level of insurance cover.
Australia's reluctance to introduce deposit insurance stems from both a lack of conviction that it was necessary and from concerns that it would create moral hazard for the institutions involved – they might be encouraged to take more risk themselves if there was less risk that depositors could lose their money.
While there has not been (and still isn't, given the insurance legislation has yet to be enacted) any explicit guarantee of deposits, there has been a community expectation – supported by government actions – that no Australian government at either federal or state level would allow a bank to fail and depositors to lose money. That expectation has been buttressed by experience.
Even in the event of a failure, depositors have priority over all other liabilities, which makes the likelihood of loss remote.
The issue that led to the decision to introduce insurance was the analogous experience of HIH policyholders, where there were considerable delays in the payment of valid claims and where the government ultimately had to intervene and create a compensation scheme.
The insurance scheme would give depositors in banks, building societies and credit unions access to the first $20,000 of their savings while they waited for the recovery and return of any amounts above the insured level. The scheme will also apply to general insurance policyholders.
The decision to create the scheme wasn't taken in response to any specific threat to the Australian institutions but was part of an international discussion on how regulators should manage the credit crisis and the potential threats to the stability of their systems. Confidence in core financial institutions, particularly banks, is critical to systemic stability.
The Australian market, where the four majors are pristine by global standards, is structurally sounder than almost any other banking system. That doesn't mean that it is immune to the general anxiety created by the failures and near-failures of banks around the world or the counterparty risks that all banks face given the necessity to deal with each other.
While the risk of depositor loss might be extremely low, the brittleness of confidence and the impact that any level of nervousness can have on an institutions' liquidity means that it is better to build confidence ahead of an event than during one, as the UK Government discovered when it tried to stop the crises of confidence in Northern Rock and Bradford & Bingley from spiralling out of control.
In the present climate, concerns about moral hazard are secondary. Whether the guarantee is for $20,000, $100,000 or 100 per cent of deposits, if depositor protection helps avert losses of confidence in important institutions it makes sense to introduce it as quickly as possible. It also makes sense to provide sufficient coverage so that any incentive to arbitrage between the levels of government guarantees on offer is minimised.
While all European governments have some form of deposit insurance (it is required by the European Union) the Irish move, which guarantees about $A750 billion of bank liabilities, set a new benchmark and reportedly triggered a flow of deposits out of UK banks into the UK branches of Irish institutions.
The fear of guarantee-inspired diversions of liquidity no doubt played a role in the British Government's decision to increase its insurance coverage from £35,000 to £50,000. It has also caused other European countries, including France, to publicly ponder following the Irish. The Americans have already lifted their deposit insurance coverage from $US100,000 to $US250,000 to try to bolster confidence in their institutions and prevent further liquidity crises.
A failure to respond to the bidding up of depositor protection levels, apart from the potential for a flow of deposits from banks with lesser guarantees, might also be interpreted by depositors as a lack of confidence by government in their own system – or a lack of capacity or will to protect depositors.
The Irish decision has been criticised by other European governments, who presumably are concerned about security-driven runs on their institutions if they don't respond. It is also being investigated by the European Union on competition policy grounds.
Australia has traditionally been unconvinced about the merits of deposit insurance. It has stood out among the developed countries as the only rich country not to provide some level of insurance. That is about to change.
After more than a decade and a half of debate dating back to the recession of the early 1990s, which saw the collapse of the Pyramid Building Society and massive losses by the major banks, the Rudd Government announced in June that it would introduce a depositor protection scheme, insuring the first $20,000 of deposits in authorised deposit-taking institutions.
The $20,000, incidentally, doesn't appear to be specified in the legislation but was the level at which the scheme was expected to start. The government said when announcing its plans that it would review them against international arrangements for deposit protection once the international arrangements were settled. Given what is happening overseas, the government might have to reconsider the opening level of insurance cover.
Australia's reluctance to introduce deposit insurance stems from both a lack of conviction that it was necessary and from concerns that it would create moral hazard for the institutions involved – they might be encouraged to take more risk themselves if there was less risk that depositors could lose their money.
While there has not been (and still isn't, given the insurance legislation has yet to be enacted) any explicit guarantee of deposits, there has been a community expectation – supported by government actions – that no Australian government at either federal or state level would allow a bank to fail and depositors to lose money. That expectation has been buttressed by experience.
Even in the event of a failure, depositors have priority over all other liabilities, which makes the likelihood of loss remote.
The issue that led to the decision to introduce insurance was the analogous experience of HIH policyholders, where there were considerable delays in the payment of valid claims and where the government ultimately had to intervene and create a compensation scheme.
The insurance scheme would give depositors in banks, building societies and credit unions access to the first $20,000 of their savings while they waited for the recovery and return of any amounts above the insured level. The scheme will also apply to general insurance policyholders.
The decision to create the scheme wasn't taken in response to any specific threat to the Australian institutions but was part of an international discussion on how regulators should manage the credit crisis and the potential threats to the stability of their systems. Confidence in core financial institutions, particularly banks, is critical to systemic stability.
The Australian market, where the four majors are pristine by global standards, is structurally sounder than almost any other banking system. That doesn't mean that it is immune to the general anxiety created by the failures and near-failures of banks around the world or the counterparty risks that all banks face given the necessity to deal with each other.
While the risk of depositor loss might be extremely low, the brittleness of confidence and the impact that any level of nervousness can have on an institutions' liquidity means that it is better to build confidence ahead of an event than during one, as the UK Government discovered when it tried to stop the crises of confidence in Northern Rock and Bradford & Bingley from spiralling out of control.
In the present climate, concerns about moral hazard are secondary. Whether the guarantee is for $20,000, $100,000 or 100 per cent of deposits, if depositor protection helps avert losses of confidence in important institutions it makes sense to introduce it as quickly as possible. It also makes sense to provide sufficient coverage so that any incentive to arbitrage between the levels of government guarantees on offer is minimised.
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