Bank deposit guarantees

I have been thinking for a long time about a very serious discussion I had with my friend Alex about bank guarantees. There was a lot of arguing going on about whether it is a good thing or a bad thing. I think that we came to the agreement that bank guarantees are good when things are bad, but extremely bad when things are a bit more bad than usual. This is an article outlining the basic concepts of what a bank deposit guarantee is, what it is good and bad for, and also talking about potential alternatives.

What is a bank deposit guarantee?

The purpose of a bank deposit guarantee is to ensure confidence in banks. It does this by guaranteeing that the money you put in your savings account up to a certain amount is safe, even if the bank becomes insolvent. If depositors did not think that their savings were permanently safe, then bank runs would be much more likely. A bank run occurs when the depositors of a bank thinks that the bank is going to fail, and hence try to take their money out of the bank.

There are two serious problems with bank runs. Firstly, banks carry only a very tiny fraction of the total deposit amount in physical cash. By the time the first few people in the queue have taken their money, the tellers have no more cash to give to the customers, which leads the masses to think that a bank is in much more trouble than it is. Secondly, people taking money out of banks quickly causes them to become under capitalised. This means that the amount of money the bank holds as deposits is very close to the amount of money out on loan. If the loans in the bank’s loan book experience any hardship such as mortgage delinquencies or foreclosure, then this translates to real losses on the depositors accounts.

A bank run is a perfect example of how humans can react en masse trying individually to preserve themselves, while actually causing themselves and others much more harm, like people pushing and jamming up the exits in a nightclub during a fire.

Regional Perspectives

It is important to think of the differences between financial systems before deciding whether strategies such as bank deposit guarantees are useful or not. In the US the bank deposit guarantee is called depositors insurance, and is run by the Federal Depositors Insurance Corporation (FDIC). The FDIC was established to ensure that when banks experience serious financial hardship, the bank will fall under the control of the FDIC. When this happens the bank is either sold to another bank (with all of the depositors funds intact) or the depositors are paid out in a cheque. The US is different to Australia in that Australia has only 4 major banks and very few small banks and credit unions, while the US has some extremely large banks but also hundreds of small banks.

During the height of the financial crisis the Australian federal government declared that it would guarantee deposits in Australian banks up to the amount of $1 000 000, worried that the analogies of a highly leveraged real estate present in both the US and Australia might result in systemic failure down under, bank runs included. There are a few interesting realities about Australian banks that make a guarantee discussion quite complicated:

  • Australia has most of its money concentrated in a very small number of extremely large banks. These banks are considered quite large when compared to many developed nations around the world. Of course there are mega giants like Bank of America and CitiBank in the US, but it is very rare to have so few banks (we only really have 4 major ones which deal with roughly 90% of accounts). If a major bank failed (for example the Commonwealth which has a massive exposure to retail mortgages), the federal government would find it difficult to find the money to pay out each of the depositors 100%.
  • If one of the major banks fails, there is unlikely to be a bidder that would be happy to take on the loan book and accounts of another extremely large bank. For a situation to arise in which a very large Australian bank were to fail, the other extremely large banks would also be under considerable pressure as well, making purchase difficult.
  • The guarantee is only up to $1 000 000. It wouldn’t take that many large accounts wiring money out of the Australian banking system to cause the banks to be undercapitalised.
  • Australia sources a lot of its funding from overseas. Complicate questions arise about whether the governments should pay private bond holders, and the implications on our currency and government borrowing.

Why are Bank Deposit Guarantees a bad thing?

You might be thinking “If bank deposit guarantees give economic stability, then they are a good thing!” However, there are several reasons why they are a bad thing:

Cost

In certain situations, yes they are good, but there is no such thing as a free lunch. To ensure stability in these banks, you must back the insurance up with capital. If a bank goes bust and there is a difference between the value of the loans and the deposits, the government has to pay, which means that you have to pay in your taxes. This is not so much of a problem in Australia, as we haven’t had any true bank failures in the last few years. In the US this is a much bigger problem. In 2008 there were 26 bank failures. In 2009 there were 140. In 2010 there were 157, and there were 92 in 2011. The cost to the US tax payer in bailouts of banks after the GFC is measured in trillions (thousands of billions).

Not properly pricing risk

It may come as a surprise to some people, but the money you put into the bank does not generate money just by sitting in your account. The money that you deposit has to be invested by loaning money to other people to charge them a lot of interest so that they can give some back to you. These funds might go to home loans, business loans, loans to governments or credit card loans. Each of these contain a certain amount of risk.

I have my money saved up in an account that offers 4.75% interest. Such a high rate of interest is only possible because they lend my deposits out to people who use my money for margin lending: high stakes speculation on the stock market. They charge margin lenders 9.5%. While the lending of money to people for margin loans is typically an extremely profitable business, if the Australian stock market were to open 30% lower tomorrow because of a massive crash on Wall Street, almost everyone would be in margin call with very little capital and basically no stock assets to back themselves up. However I get the same government guarantee just like anyone else.

Economic theory generally assumes that investments with potentially higher returns entail a greater risk of losses. It’s a trade-off between risk and profit. Bank guarantees remove the incentive to choose safer investment strategies by ignoring the way in which the deposits are invested. This is bad because it reduces the desire for individuals to make rational decisions about risk when choosing where to place their money (including which institution to have their savings accounts with), which can lead to economic bubbles and other market mayhem.

Deferred risk

Another problem is deferred risk. By insuring bank deposits, we defer risk to other people and future times. I’m possibly putting risk on to the government (and therefore fellow tax payers) by investing cash in Comsec. I’m getting more return for the same risk to me, which is essentially zero. Depending on who you ask, some people would say that I am almost stealing from others because Comsec is much more likely to fall as a lender. Others would say that the Commonwealth is much more of a risk than other banks because their loan book is almost entirely home loans (and hence putting all of the bank’s eggs in the same basket).

Insurance also defers risk to later times. With insurance stopping runs on banks, financial transactions run a lot more smoothly. A functioning financial system is necessary for effective capitalism to continue. Hence if a number of banks fail, the whole system doesn’t come down with it when all depositors try to take their cash out. It sounds good, but when many, many large banks all fail at once, government and society faces massive pressures. Firstly taking on the debts of banks to guarantee the savings in people’s deposits adds to government debt, which must eventually be paid off. This leads to situations similar to the US, where the massive cost of providing financial backing to the banking sector has in part caused the US to have debts which seem difficult to pay off. While education budgets and health budgets are suffering, the government is required to service these new loans. A governmental default (in addition to massive bank failures) is likely to cause large and on going consequences for the country involved. If the size and the number of failures are big enough, then the government may be unable to pay out all depositors, rendering the whole concept of deposit guarantees useless.

A world without deposit guarantees

If we think that deposit guarantees are a bad thing, what would the world look like without them? I can think of 3 scenarios which could be either likely outcomes or could work.

Scenario 1: Business as usual

I see this as the mostly likely outcome, but to me is also the least satisfactory. Currently consumers are left in the dark as to how their deposits are invested and what their deposits are earning in interest rates. This void of information for consumers is a deliberate move by the banks to ensure that they don’t understand the size of the difference between the rates the banks charge for loans and the rates they give you for your savings. By not knowing how your money is invested, you don’t understand how at risk your money is, especially if bank goes bust.

This issue is compounded by the fact that money is mostly electronic these days. A very small percentage of the total money supply is actually physical cash. That means that the days of hiding your money under the mattress are long gone. Essentially there is no way for you to take all your cash and keep it somewhere where it won’t disappear. We don’t have  0% interest “under the mattress” accounts where cash is guaranteed to be paid out at anytime. If such an account existed, they would have zero risk of loss (except for the inevitable effects of currency depreciation) by having 0% invested in loans. While I would never use this, I argue that people should be allowed to keep their cash (or a proportion thereof) in the equivalent of an electronic money safe. This does not exist at the moment. Of course you could keep all your money in your transaction account and earn close to zero percent, but your money is just as much at risk as anyone else’s money if the bank fails.

In the modern world, there is no choice in how or whether your money is invested when you put it into the bank. But more importantly, you do not know how it is invested and therefore you cannot make rational investment decisions about whether the larger interest rate is worth the extra risk.

This scenario leaves the banks prone to bank runs, based on either false rumour or runs with legitimate reasons. Uncertainty about the nature of the banks holdings may exacerbate the problem, for example if one of the many large investments a bank makes fails, this may trigger a run despite the investment making a very small dent to the balance sheet.

Scenario 2: Business as usual, but with greater consumer information

Banks provide a valuable service to their depositors, by taking their relatively small deposits and spreading them over a large number of loans, thereby spreading risk. Without banks person A would loan their money to person B, and if person B goes bankrupt, person A could lose everything, which is a bad scenario. Banks allow person A to take their deposit and break it up into millions of tiny loans to person B, C, D, …. such that if 0.1% of loans fail the depositor only loses 0.1%.

Given that banks provide us with a useful service by spreading out our investment, we should at least know how they do it. If I am trying to work out which bank to choose, I should consider the interest rate of the accounts and whether my funds are going to be mostly invested in houses, business loans or the share market. These are important considerations when dealing with risks. While retail depositors would be quite far from theoretical rational market agents due to massive information asymmetry, they should be more rational when they are given more information.

Unfortunately while this information allows me as a depositor to make decisions about how my money is invested, it still doesn’t prevent bank runs. If house prices collapse, Commonwealth might see a bank run. If share prices fall, ComSec would likely see a bank run. And if whatever business UBank invests in happens to drop in price, then UBank will experience a drop.

If you were to let the market correct for such problems, you would find that interest rates would move around a bit quicker than they currently do now. While not necessarily a problem for economics theoretically, rapid interest rate movements can make decisions about long-term projects more difficult for companies. Most economists would agree that keeping the interest rates generally steady (if the economic conditions support it) is prefered.

Scenario 3: Redefine what a bank is

Point of this article so far is to give weight to what I think a bank should be redefined as. People, when investing their money, should take responsibility for the various choices they make. However, to make those decisions, they also must be informed.

My proposal is to destroy the concept of a bank acting as a black box, always giving the same interest rate to depositors while playing the market to borrowers.  Instead banks will be companies that package loans and deliver them to depositors to buy. These loans will be made up of particular sectors such as real estate, small business, medium business, large business (asx 200), government bonds etc.

To ensure stability in the market place and to ensure people don’t have to daily check on their finances, I would suggest that the majority of these savings investments should be fixed-term deposits. These deposits could earn a good deal more than

The reason I argue for fixed terms is that having variable interest rates that change daily would be frustrating both to depositors and people who take out loans. In most cases, people have small amounts invested (in the order of a few thousand dollars) and shouldn’t have to deal with information overload from such a small amount of savings.

In such a scenario, banks would essentially become packagers for financial products, where they charge fees for stitching a very large number of loans together.

To ensure that banks do not create financial devices that they do not believe in, it would be necessary for the bank itself to have skin in the game. One of the problems of the global financial crisis was that financial institutions were packaging up poor quality home loans and giving them high ratings while secretly betting against such loans to the detriment of their own customers. To avoid this, banks will need to have a certain percentage of their own money on each of these loans. The proportion of each of these loans (say 10%) must be financed directly by the bank itself. This way, underperforming loans will affect the profits of the bank in the same that a customer’s account would be affected.

Concluding remarks

Most of this is just theory, and there are additional requirements (beyond scenario 3) of adjusting the financial system to avoid direct government support. That said, removal of government support for the financial industry is an important aim to have. We don’t want governments supporting big banks and the already wealthy while cutting health spending and education budgets.

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