Doing a better job of guaranteeing deposits

The collapse of South Canterbury Finance (SCF) and the $1.6bn taxpayer bail-out has turned the spotlight firmly on the government's deposit guarantee scheme.  Originally introduced in October 2008 at the height of the global financial crisis, the scheme's intent was to give investors’ confidence that their money in New Zealand banks and financial institutions would be safe.  The scheme came at a time when institutions were failing both here and overseas, and there was a real risk of bank run contagion as investors wanted to withdraw their money before their own bank of choice hit the wall.

The popular story goes that the Reserve Bank of Australia rang up our own Reserve Bank on a Saturday night and said, “We’re announcing a scheme to underwrite our banks tomorrow what are you going to do?"  Although our government officials had been working on a scheme, the pressure was suddenly on to flesh out the details overnight literally.  In the end, the New Zealand government announced its scheme the same day as Australia, but the process was inevitably a rushed one.

Government policies such as these are imperfect at the best of times, and even less perfect when haste is involved. In interviews coinciding with the release of a book about his experiences during the global financial crisis, Alan Bollard has stated that he was "very reluctant to have to get into a deposit guarantee scheme, with all the distortions and adverse incentives that it offered [but that] the possibility of not doing it was far worse."

So the Reserve Bank governors back-of-the-envelope analysis of the deposit guarantee scheme suggests that, despite the bill to the taxpayer, the benefits of the scheme have outweighed the costs.  But it's virtually impossible to know how bad things might have been if the scheme wasn't put in place, so coming to a firm conclusion one way or another is difficult.

On the positive side, the scheme has prevented New Zealand's healthy financial institutions being forced out of business by withdrawals en masse.  Even the inability of the scheme to prevent the collapse of SCF, Mascot Finance, and others should not be seen as failure.

But some of the scheme's costs are easy to spot in the case of SCF.  It is questionable how useful it was to keep SCF trading for another 22 months given the non-performing lending on its books.

One of the least surprising "revelations “about SCF's activity over the last two years is that the deposit guarantee scheme allowed the company to expand its high-risk lending.  Historically the company did not have much exposure to non-rural property, but it had been increasing its lending to property development.  This trend continued even as other finance companies were failing due to an overexposure to property development.

Interestingly, Dr Bollard stated last weekend that SCF "wasn't one that we had any particular reason to worry about at that stage [in 2008]."  Clearly, subsequent lending decisions have been a factor in the company's demise.  In a world of significantly tighter credit conditions, the market signals to SCF to change its lending behaviour were diluted by the presence of the scheme.  The ability of SCF to keep attracting deposits was boosted by the fact that the high interest rates it offered to depositors were effectively government guaranteed as well.

So what lessons can we learn from this experience? Firstly, if the government is going to get into the business of insuring financial institutions, it needs to set its premiums with an eye on risk. There is no way the second and third-tier lenders should have been accepted into the scheme on the same terms, or even more favourable terms, than the banks.

Secondly, there need to be restrictions on new lending once an institution is in such a scheme.  The government's aim was to prevent the failure of healthy institutions, not to facilitate continued lack of discipline in lending decisions.

Thirdly, there is no way that inflated interest payments should be covered under the scheme.  Once an institution is underwritten by the government, the risk for a depositor is the same as investing in any other government-backed company.  Guaranteeing 8.5% interest at SCF but only 3% interest at Westpac makes no sense.

Hopefully, financial crises akin to events of the last two years are a once-in-a-lifetime event.  In the 1930s, policymakers learnt from the bank runs and contractionary fiscal policies that contributed to the Great Depression.  Many of those lessons have been applied during the global financial crisis of the 2000s, some have needed to be relearned, and there has also been a new set of lessons to learn.  By the time the next crisis hits in the 2080s, the policy approach is still likely to be imperfect, but hopefully it will be more refined.

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