Monday, February 25, 2013

Should the Australian government continue to guarantee bank deposits?

In a recent post I suggested that government guarantees of bank deposits tend to encourage banks to become highly geared because they make depositors less cautious about depositing their funds with banks that are at greater risk of default. Such guarantees could be expected to make it possible for highly geared banks to obtain access to deposits at lower cost than would otherwise be possible.

A regular reader of the blog, kvd, objected to my reasoning. In his comments he suggested:
 'your acceptance that 'the market' should play any part in the securitisation of depositors' funds (alongside equity participants) offends against my own beliefs. …

I would not seek in any way to regulate or limit the rich investing their money in any way they wish. But government failure to differentiate between the basic needs of their populace, and the desires of a relatively small, select group of players - that I find a complete abrogation of a basic government role - more specifically, a responsibility.

By all means let's limit government involvement and guarantee - but let's first more clearly delineate what it is that government should be obliged to protect.' 

In the subsequent discussion kvd clarified that what offended against his beliefs was the idea that depositors should be expected to take account of differences in the risks involved in placing their funds in different institutions. 

He explained his position further in a later comment:
 'My interest was initially piqued by what I referred to as the 'securitisation' of a significant part of the funds sources available to banking institutions - namely those funds deposited in the ordinary course of getting on with one's life. If you accept my figures, this amounts to somewhere north of 20% of the funds available for them to pursue their objectives.
While I would be the last to suggest any of the 'big four' are in danger of collapse, I do think that in your higher level analysis of 'marketplaces' and 'risk assessment' it begs the question as to just what is represented by the 20+% of unsecured creditors (because that's effectively how depositors' funds are treated; and that's why there were recent queues outside various high street banks and building societies in the UK) which I termed 'transactors'.

My simple point remains that these funds should be regarded more as the old fashioned 'Trust Fund' one sees in any solicitors' practice. Yet that is not where they presently sit in calculation of leveraging. Within that they are subsumed in those funds available to satisfy any higher-secured obligation. Except for shareholders, they are in fact last in the queue, along with any other trade creditor.

When one thinks of such funds, Winton mentions the 'mum and dad investor'; the implication being that the sums are small, difficult to manage, an annoyance really in terms of transaction costs. [Editorial note: I didn't intend to imply that the sums are small or an annoyance to banks.]
But when I think of those funds I'm referring to my working cheque account …  . These funds are sloshing around in the banking system, available (God forbid) at any time for our banks to satisfy secured creditors. Come a crunch, my funds are essentially an unsecured interest free loan to my bank, available for them to pursue (did you term it?) enhanced shareholder returns.
Too much regulation involved to protect such funds? I'd suggest a reclassification of such funds as first charge government backed liability. Would that would necessitate a recalculation of the risk attaching to other funding sources? Yes, and so be it; the market will decide that.'

Before considering the question of bank guarantees, I will first attempt to consider whether it would be possible or sensible to make the status of bank deposits more like that of solicitor's trust funds. I write 'attempt' because my knowledge of the law concerning solicitor's trust funds is rudimentary. My understanding is that solicitor' trust funds remain the property of the client. There is a great deal of regulation about what solicitors can do with those funds but I expect that they would normally be deposited in a trust account at a bank. That would probably be the safest thing to do with them, even though the funds might still be at risk in the event of bank failure. Perhaps that risk might be covered by solicitor's insurance, I don't know.

The underlying point that kvd is making seems to be that, in the event of default, depositors should be accorded the same ranking as secured creditors. My immediate reaction was that it might be difficult to give depositors a lien over a bank's loan portfolio, but further thought led me to the view that there is nothing to prevent bank deposits from being secured by a lien over other bank assets such as holdings of government securities.

The idea of giving a class of depositors a lien over a bank's holdings of a particular class of assets makes a lot of sense to me. In the absence of government guarantees, this could be expected to be most attractive in relation to transaction accounts of those depositors who are most concerned about security. As at present, such deposits would earn little or no interest and transactions charges would apply. The important point is that these deposits could be expected to be fully covered against loss in the event of bank default – unless, of course, shits are trumps and bank default is caused by default by governments (in which case, government guarantees would also be worthless).  

So, let us now consider whether the government guarantee of deposits should remain in place. Some recent history might help.

Banking in Australia functioned without a government guarantee of deposits prior to the global financial crisis. The Wallis report into the financial system (1997) recommended against the introduction of government-backed deposit insurance on the grounds that it 'was not convinced that such a scheme would provide a substantially better approach or additional benefits compared with the existing depositor preference mechanism' (p355). According to Wallis, the depositor preference mechanism 'provides that the assets of a bank shall be available to meet depositor liabilities prior to all other liabilities of the bank' (p 354).

An article on depositor protection by Grant Turner (RBA Bulletin 2011) suggests that the recommendation against deposit insurance by the Wallis inquiry 'reflected concerns that introducing deposit insurance could weaken incentives to monitor and manage risk' (p 49).

In my view such concerns are warranted. I can understand that depositor guarantees were considered desirable in the midst of the global financial crisis, but it would be good to be rid of them as soon as possible. The best way to phase out such guarantees would be to make them unnecessary by ensuring that governments will never be called upon to honour them. Could that be achieved by requiring that the guarantees will apply only to deposits that are secured by a lien on government securities held by deposit-taking institutions?


I have had second thoughts on the question of how the deposit guarantee should be removed.

My further discussion with kvd, see comments below, makes it clear that in the absence of the guarantee, deposits would rank after secured liabilities in the event of bank liquidation. This has become particularly important since the guarantee was made 'permanent' because the existence of the guarantee has been used as an excuse to allow banks to raise funds using covered bonds (i.e. secured liabilities).

It is probably reasonable to expect that if the deposit guarantee was removed, the market would eventually find a way to give demand deposits the highest priority in the event of bank liquidation. However, it might take some time before banks began to see it as in their interests to provide sufficient asset backing to demand deposits to enable that to occur.

It seems unlikely that any government would remove the guarantee unless it considered depositors to be adequately protected. I think that could be achieved by giving demand deposits the priority that is currently accorded to APRA in order to recover funds it pays to depositors under the current guarantee arrangement. As I understand the situation, the Banking Act gives debts and liabilities to APRA the highest priority in the event of bank liquidation.

In my view, legislation should give demand deposits the highest priority in the event of bank liquidation in order to maximize the potential for banks to be able to honour the promises that they make to allow depositors to withdraw such funds on demand. 


Anonymous said...

Winton, with all respect, you are not taking my point. I am specifically stating that what you and the Wallis report call "depositors' funds" be accorded first rank in any bank failure. Not first rank within the unsecured creditors; first rank above all other levels of secured funds.

This term 'depositor preference' and garbled discussion about the benefit of some form of 'insurance' - possibly 'capped' - is not recognising the position that I'm suggesting: first rank before any other liability - no ifs no buts.

I'd be very interested to get a link to your source (p355 et al) because I believe what is being discussed is the possibility of ranking depositor funds above other unsecured creditors, and the concept of insuring same. This is far less than I'm suggesting.

Here's a comment about the UK Building Society position:

Depositor preference: The government supports insured depositor preference ie changing the creditor hierarchy so that depositors insured under the FSCS are preferred in an insolvency to the claims of other senior unsecured creditors. This should also apply to Building Societies but currently unsecured creditors are ranked above retail depositors and the creditor hierarchy will need to be changed to achieve consistency.

And here's a comment from the Wallis summary - about Super Funds, but I'm sure you will see the wider point I made about 'transactors' who by government monopoly are forced to use banks for their daily business:

The arguable exception to this general rule is superannuation. The compulsory nature of some superannuation savings, the lack of choice for a large proportion of members, the mandatory long-term nature of superannuation and the contribution to superannuation of tax revenue forgone provide a case for prudential regulation of all superannuation funds, even where investors have knowingly accepted market risk.

I mean, really it is a joke to single out super contributers as some sort of preferred class of powerless users of an arbitrary system. What about my cheque account?

To illustrate the problem:

Bank A has funds of $200 provided solely by depositors. Bank B has $200 funds provided by lenders who hold first mortgage over all assets of the Bank.

Question: Which bank would you be more comfortable lending a secured $100 to?


Anonymous said...

ps: runs on banks are never caused by Mr Rich wanting immediate repayment of his fully secured $1M. They are caused by Mr & Mrs Average concerned to pay their next rent, electricity, food bill.

And they are not stupid; they know exactly where they sit in terms of their bank's priorities.


Winton Bates said...

kvd: the link you were looking for on the word 'recommended' seems to be working.

I will think further about your other comments.

Anonymous said...

It is interesting to note that deposit insurance could provide a neat solution to the safety problems surrounding foreign bank branches in Australia. Such branches could be allowed to accept retail deposits provided they were insured. This would facilitate the benefits of the extra competition that branches would bring while at the same time guaranteeing full security, up to the capped level, for such retail deposits.

From here:

Which I would condense to simply mean that depositor funds are presently ranked lower than secured funds.

Which is my point exactly, precisely.


Anonymous said...

Sorry Winton - the link from 'recommended' loads a 64 page pdf of ch8 from the Wallis report? I'm having trouble translating that to your 'p355'.


Winton Bates said...

kvd: The page numbers in the Wallis report are at the bottom right hand side of each page. Pages 354 and 355 are towards the end of Chapter 8.

The article by Grant Turner, referred to above, makes it clear that despite 'depositor preference', deposits do not rank above covered bonds. He notes that the government legislated to enable banks to issue covered bonds after making its guarantee of deposits 'permanent'. (See the section on depositor preference towards the end of the article on page 54.) Those arrangements would need to be unwound if deposit guarantees were removed. As part of its guarantee arrangement (FCS) the government has ensured that in order to cover its costs it has a priority claim on the assets of an ADI in the liquidation process. If the guarantee was removed, the legislation could presumably be amended to give that priority claim to deposits that are currently protected by the guarantee.

Anonymous said...

Winton thank you for pointing out what was right under my nose! I simply did not notice the page numbering you've now referred me to - thank you.

But in reading p355 and onwards, I notice the quote you chose to highlight is immediately followed by On balance, the Inquiry was of the opinion that depositor preference on liquidation would provide a greater level of depositor protection than an explicit deposit insurance scheme - which, taken at face value, is just my point.

But the thing which is underlying all of this is just what is meant by depositor preference? In your own quote it appears as if depositor claims (and for the moment let's forget about caps, and which accounts are covered, etc) are preferenced in front of all other creditors - but from this pdf:

- I quote para 45 as follows: In Australia this is addressed by legally stipulating depositor
preference in the winding up of an ADI (i.e., depositors have a higher claim priority than
other unsecured creditors

There is a vast difference between being first above all other creditors, and being first of the unsecured creditors.

Anyway, not to worry! It'll never happen. Until it does.

ps hope that link works out.

Winton Bates said...

kvd: I think we are now more or less on the same page in relation to the factual position.

Grant Turner (see link above)spells out the relevant provision of the Banking Act. Section 13A apparently states that if an Australian ADI is wound up, all of
its assets in Australia are first made available to APRA
(on behalf of the Government) to recover amounts
paid out to depositors under the FCS, and then any
other debts owed to APRA in relation to expenses
incurred in operating the FCS. Thereafter, the failed
ADI’s remaining assets in Australia must be used to
repay any deposits in Australia above the FCS cap
before they can be used to repay other unsecured

That seems to suggest that APRA takes priority over secured creditors.

We seem to be agreeing that depositor preference would be preferable to the FCS if it meant that trading deposits were given priority over all other liabilities (including covered bonds and other secured debt). As I suggested in my last message, that could presumably be achieved by giving depositors the status that the legislation currently gives to APRA.

Anonymous said...

Winton, right up front in Turner's note he specifically states "They have a priority claim on the assets of a failed ADI ahead of other unsecured creditors"

This is not the same as having a right in preference to all creditors.

Until the difference between those two statements is appreciated, we are (unfortunately) not on the same page.

The 'status' given to APRA is simply that of a 'stand in' for those amounts it pays under the guarentee - i.e. it replaces those depositors it has paid; but it doesn't miraculously advance to the head of the queue in front of (for instance) covered bond holders or any creditor with specific claim to any part of the assets of the defunct institution.

Anyway, I'm now quite embarrassed about the amount of your time I have taken up. Apologies.


Winton Bates said...

kvd: I'm not a lawyer and I don't believe governments can work miracles, but Section 13A of the Banking ACT 1959 does seem to me to give APRA priority over all other liabilities. I quote:

"Priorities for application of assets of ADI in Australia

(3) If an ADI becomes unable to meet its obligations or suspends payment, the assets of the ADI in Australia are to be available to meet the ADI's liabilities in the following order:

(a) first, the ADI's liabilities (if any) to APRA because of the rights APRA has against the ADI because of section 16AI;

(b) second, the ADI's debts (if any) to APRA under section 16AO;

(c) third, the ADI's liabilities (if any) in Australia in relation to protected accounts that account-holders keep with the ADI;

(d) fourth, the ADI's debts (if any) to the Reserve Bank;

(e) fifth, the ADI's liabilities (if any) under an industry support contract that is certified under section 11CB;

(f) sixth, the ADI's other liabilities (if any) in the order of their priority apart from this subsection."

Anonymous said...

Winton thank you for your forebearance in responding to my comments. I now think (particularly after your postscript) that we are surely on the same page, but I wanted to record my thanks for your 'teasing out' (as Jim is fond of saying) what it is that is important about the issue.

But, and I am also not a lawyer, it still leaves some queries unanswered in my mind: some of the reading I've done seems to indicate that the now current government guarantee is limited to $250k per depositor, not per account; and also the issue of covered bonds seems to overlay entitlements anyway.

Whatever. The title of this post, for mine, provokes the answer "yes".


Winton Bates said...

Thanks kvd. We ended up on the same page, with some questions unanswered - and came to different conclusions!

Anonymous said...

Hi Winton

Smiled when I read this

- and thought of you.


Winton Bates said...

Thanks kvd. I had missed that. I find it hard to see the justification unless the terms are less concessional than might otherwise be offered to the banks in the middle of a major financial crisis.

BTW, did you see the recent Four Corners discussion about people losing their life savings in debentures in mortgage companies that are tied up with developers? It looks as though the promoters make their money legally by charging high management fees. The program had even me wondering what could be done to stop this kind of thing.

Anonymous said...

I must confess I went to bed instead of watching that program; I am quite familiar with the particular case, as I've followed it for more months than 4C spent on research. Along with all the other, quite similar, instances of basically the same scenario.

It's an interest of mine, to see how far greed will out-vote common sense, and how ineffective our so-called regulators really are. Still, as a (very) wise man said only recently:

I have some sympathy with the idea of protecting mum and dad(and grandma)from the evil bankers but I'm not sure they actually want that protection. They seem to prefer to live dangerously and deal with firms like Pyramid and Banksia rather than the four pillars.

The thing which gets my goat is that we (the people) seem to foot the bill, either directly via bailout, or indirectly via increased (costly, yet laughably ineffective) regulation.

I'd offer a couple of 'solutions' to you:

1) Any financial entity receiving these sorts of funds be subject to an automatic 50% withholding tax based upon an arbitrary estimate of interest earnings of 15% - payable quarterly in advance. Automatic cancellation of business if 7 days in arrears.

2) Any director/principal of any failed scheme be subject to an arbitrary minimum 5 year jail sentence - no ifs or buts, no excuses.

3) Any auditor involved in signing off on these books arbitrarily lose their certificate for five years. No ifs or buts, again.

4) No (absolutely no) funds from any such entity be permitted to be remitted overseas.

But as you said, greed can't really be regulated out of existence. Or stupidity.


Anonymous said...

Winton, just a postscript.

I've been reading your stuff for quite a while now, and have come to think that where regulation fails is that it 'slaps with a wet feather' those it eventually finds at fault.

I'm now thinking that ever increasing fines and penalties are a nonsense because most of those are able to be insured against. Look at director's liability, and my own Institute is in the process yet again of seeking to 'monetise' (then insure) against malpractise.

So I'm saying bring back the lash! Not really; what I'd suggest is arbitrary, non-negotiable prison time - not fines - which seem to be either paid by the entity, or insured.

Can't remember seeing any insurance policy offered against prison. Might be a good thing; what say you?


Winton Bates said...

Hello kvd,
Your solution might stamp out the problem, but it might also stop a lot of useful activities at the same time. There is a risk that if business becomes too heavily regulated it becomes impossible to conduct without breaking the law. We could end up with private sector consisting mainly of black market activities controlled by criminals, who bribe government officials to look the other way.

One of the things that struck me about some of the business models discussed in the Four Corners program was that they seem to be functioning well within the law. There is sufficient disclosure that investors should be well aware that they are taking huge risks to obtain, at best, modest returns after management fees have been paid.

I think the solution probably lies in the direction of better public education in financial matters. People would usually avoid disaster if they followed a few basic rules when they make major investments. For example: don't put all your eggs in one basket; deal with reputable firms; seek independent advice.

You make an interesting point about prison verses fines as a deterrent. I tend to agree that white collar criminals get off too lightly for theft and fraud. It becomes more difficult when we are dealing with behaviour that is more like negligence or incompetence than fraud. There are times when I think it would be a good idea to send some auditors and company directors to jail for their incompetence (as well as a fair few public servants) but most of the time I think there are already too many people in jail.

Perhaps it would be a good idea to make more difficult for people to sue for defamation if they are named and shamed for engaging in dubious business practices or incompetence.

Winton Bates said...

I had a further thought. Perhaps disclosure rules could be tightened up to ensure that investors are aware of the nature of their investment.

One lady who lost money in Banksia told Four Corners that she thought she was depositing money in a bank. The name of the firm sounded like a bank and it looked like a bank, but it wasn't even an ADI.

Perhaps 'health warnings' could be mandatory for public offerings of securities when equity of owners in the project is expected to fall below some minimal percentage. One of the best safeguards that debenture holders can have is knowledge that owners of the firm stand to make substantial losses if the firm goes bust.

Anonymous said...

Winton, you've no doubt read this, but just for history's sake here's an ABC report on Prime:

I'm most interested in the commentary towards the end which seems to align (not in an good way) with your own thoughts about disclosure.

The other punchline, possibly different from the other similar farces, is that the machinations involved breaking no actual laws. This reinforces my thought that what presently exists by way of regulation and law is coming at the problem from the wrong end.

What I mean is, everyone with half a brain cell can tell that a large amount of money ended up in the wrongs hands. I'd be interested to see if some sort of reverse 'cui bono rule' could be applied, whereby such funds as remain (within Aus) be returned to those who should have been regarded as the 'rightful' owners of same, irrespective of the clever legal machinations on the way through.

A version of this already exists in taxation laws, whereby the ATO or courts can 'look through' perfectly valid transactions which are themselves deemed then to be for the purpose of defeating the intent of the tax laws.

And I'm all out of further 2c's worth at that point.


Winton Bates said...

Perhaps there might be a case to make it illegal to charge a fee for a service that is far in excess of the fee normally charged, irrespective of whether there has been prior disclosure of an intention to levy the fee. I can't think of a situation where charging more than the market price would not involve something dodgy.

If the service provider is not able to repay the excessive amount because of gifts made in the last x years, then perhaps those gifts should also be recoverable.

Anonymous said...

Hi Winton

I suppose you've been following the Cyprus bailout proposals as closely as I have. The following Telegraph UK link seems a reasonable summary:

I mainly include it so as to make a point I meant to mention several times, but simply overlooked. Just as mentioned in this article, I understand that government backing in Aus is on the basis of 'one person, per institution'. I hope and expect that this would never become more than academic in Australia, but it appears to be causing some practical angst in Europe just now.

regards, kvd

Winton Bates said...

Hi kvd, I have been following the situation with great interest.

It underlines that depositors can only expect government guarantees to be fully honoured when governments have low debt levels and bank liabilities are relatively low compared to GDP.

Anonymous said...

Or you could look to New Zealand, where I see the name for it is "Open Bank Resolution". As in the Ministry of Peace" etc...

BTW hope the comment moderation wasn't in response to my polite attempts.


Winton Bates said...

Thanks for the info about NZ. I wasn't aware.
I don't think insurance is as simple as David Mayes suggests - it would take a lot of time to build up an insurance fund.
I wonder whether the fact that banks in NZ are largely foreign owned makes any difference. It might give the NZ government additional leverage if there is risk of default, or it could mean that NZ depositors are at the end of a long queue.

Re comment moderation, there is no need for concern. I put it in place automatically for posts more than a few weeks old - mainly to be sure that I was notified.

Anonymous said...

Fascinating interchange gents. Can you clarify where you agreed: in the FCS, does APRA rank ahead of secured creditors in its claim to the banks assets? If so, then APRA, acting on behalf of depositors, effectively allows unsecured creditors (depositors) first claim on the assets ahead of secured creditors? Have I got that right?

Winton Bates said...

My understanding is that APRA does rank ahead of secured creditors.

Provided the value of assets of the insolvent bank is sufficient to fully compensate APRA for the amounts advanced to protected depositors, I think the process could be viewed as equivalent to giving the protected depositors the first claim. It is possible that circumstances could sometimes arise where APRA would not be fully compensated. It is also possible that protected depositors might get access to their money more quickly under the current guarantee arrangement.