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.