Taxpayers taking risky bet on Kiwibank

There has been public debate recently about the merits or otherwise of selling or partially selling Kiwibank.  Public opinion is currently strongly in favour of the Government retaining 100 percent ownership of the bank.  Bowing to this support, and belatedly recognising pre-election pledges from Prime Minister John Key not to sell Kiwibank, the Government has indicated it will not seek to offload the bank in part or whole.  That is a pity because over time taxpayers could pay a high price for this investment.

Kiwibank was established in 2002 on the belief that the cost of existing banking services in New Zealand was too high, although purely jingoistic concerns about Australian domination of the New Zealand banking market were also undoubtedly influential.  Since its inception Kiwibank has operated successfully winning customer service awards and gaining a loyal clientele.  Its initial success was helped considerably by its entry into the market during the financial boom times of the last decade.  The bank's government ownership also arguably assisted it in the early stages of the global financial crisis as depositors sought the safest places to put their money.  Nevertheless, the Kiwibank management can take credit for professionally taking advantage of conditions and guiding the bank to success.

But despite its success so far, there are several reasons why continued public ownership of Kiwibank represents poor economic policy. First, the bank's establishment was not based on clear identification of the problem it was attempting to fix.  If costs to customers were indeed too high, was this because of an impediment to competition in the banking market, or was it because customers were unable to fully comprehend the costs banks were charging them?  The most cost effective policies attack problems at their source.  Are the banks colluding? Punish the colluders.  Is there monopoly power?  Put restrictions on bank pricing.  Is there a lack of transparency about pricing?  Force public disclosure of information.  Do customers not understand pricing for bank services?  Require banks to give information in plain language and educate customers.

Ownership of Kiwibank involves high risks to taxpayers, especially compared to alternative policies that would achieve the same objectives. The core of a bank's business involves taking deposits and lending to borrowers. It makes a margin on this business by charging borrowers a higher interest rate than it pays to depositors. But, the amount a bank lends is typically many times higher than its capital base, thereby magnifying the gross margin it earns from the difference between its cost of funding and lending rates. In normal circumstances banks manage this mismatch between deposits and lending through maturity matching and other financial hedging. But when events turn sour and depositors lose confidence, banks can quickly become insolvent. This has been demonstrated through history with the frequency and severity of bank failures in New Zealand and many countries around the world.

The nature of government ownership means that publicly-owned banks tend to be riskier over time than privately owned banks.  This is not because of any inherent skill deficiencies on the part of the managers of government-owned banks.  Rather, it is because they do not face the same sharp incentives that private banks do to perform well and manage their risks effectively.  Bad performance by a private bank will be punished by the market.  Poor performance by a government-owned bank will ultimately be treated depending on the whims and political priorities of politicians.  Even the best efforts to keep a government-owned bank's operations at arm's length from political influence are only as robust as the commitment of successive regimes to maintaining that independence.

An opaque and pervasive cost of public bank ownership is the subsidy the bank receives through the government's backing.  This subsidy is not explicit, but arises as a result of what economist’s term moral hazard – the disregard by managers and depositors of some of the true market risks associated with bank investments because of the belief that it will be saved by the government if it gets into financial difficulty.  The consequence of this implicit guarantee is that depositors and lenders will generally require a lower interest rate on funds invested in Kiwibank than they would of a bank of a similar size and financial standing.  On the other side of the coin, managers will be incentivised to seek investments or lending opportunities that offer higher risks and returns than private banks which face higher funding costs without the implicit guarantee.

New Zealand has a sorry history of publicly owned banks over the past 20 years with the collapse of the Development Finance Corporation and the bailout of the Bank of New Zealand.  The risky nature of banking means that the distortions created by government ownership magnify the potential costs associated with government banks.  Selling all or part of Kiwibank would enable the public capital currently tied up in it to be redirected to less risky and more economically beneficial uses, such as public infrastructure or repayment of government debt.  Any deficiencies in the banking market can be addressed through far less costly measures that more directly target the source of the problems.

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