As any lady will tell you, a trip to the hairdresser is a serious business. A bad haircut is not a good day out and could spark major dramas, which may reverberate for a long time. A trip to the bank, however, is generally not considered high on the list of things that could go wrong but in the last few months that has changed.
Banks have been pulling down the shutters for sometime now, starting with the very public collapse of Northern Rock in the UK. Long queues of customers outside a bank is never a good look and the UK government wasted no time in stepping in to guarantee the deposits of Northern Rock, fearing, quite rightly, a panic and a run on the banks. Nearly 6 years on, governments are still none the wiser about how to handle the situation where a bank falls into funding problems and finds its assets falling below its liabilities. The wholesale guarantee of deposits was a short term answer to a difficult situation and forced many countries, including NZ, to follow suit.
Since the parlous days of 2007/2008, time has passed, QE has reflated financial markets and deposit guarantees are no longer de rigeur. In fact, there has been a shift away from any kind of government underwrite and a move towards what is known as “The Haircut”. As the metaphor implies, this is not a wash and blow dry but a loss of hair. Whether it’s a trim, a short back and sides or a number one, is unknown. But be clear, this will not be something you are likely to be happy with.
The Haircut was made famous during the blow up of the somewhat shaky Cyprus banking system. Depositors woke up one morning to hear that their banks had been closed and they could not access their funds. Again, as we saw with the GFC, lax bank lending and dubious bank investments had created a very unstable situation for depositors. The new banking model, so glorified by the deregulated delights of the last 30 years, had allowed banks to lend or invest first and then look for deposits afterwards. This shift to banks as speculators, rather than lenders of deposits, had created poor incentives and a spiral of greed, as the search for easy yield saw voracious amounts of new lending. As is always the case, the party ended in tears and recriminations all round. The original Cyprus Haircut recently upgraded to a full Brazilian Wax (ouch!), with depositors foregoing a whopping 47.5% of their original funds.
So what for New Zealand? Well, the Reserve Bank has promoted an Open Bank Resolution approach, which essentially sees the banking system operating within the spirit of caveat emptor or for the layman, learn to read bank’s balance sheet (good luck with that). Deposit insurance is seen as a moral hazard, which makes absolute sense, but only if you have a very advanced understanding of how to work out the risk and liquidity profile of your bank. Let’s face it, so far we haven’t seen any evidence that even the central bankers can do this job. Still, the intent to make depositors responsible for where they stick their funds is admirable, if somewhat hopeful. So with that in mind, it pays to make cursory inspection of the capital structure of a bank, so you can see where your deposit ranks. (Long time readers of this blog will already know that a bank deposit is an unsecured liability of the bank!). Go figure. Essentially, bank shareholders take the first hit, which is appropriate, and if that cash runs out, then the scissors move down the line from unsecured bondholders to depositors and the dreaded covered bondholders. Let’s really hope we never get down that far, because I wouldn’t want to be picking over the legal carcass of a covered bond. Messy. Gareth Vaughan gives a clear explanation here (make sure to read the comments also).
I think the OBR has merits but really the Reserve Bank has a lot of work to do with its communication of the policy, as well as its explanation of how the banking system actually works. I’d prefer to see even a small deposit guarantee scheme (e.g. $50,000). It will allow the majority of the population to sleep well at night. And yes, the banks can pay for it (and afford it without breaking sweat). Generally speaking, the NZ banking system is well capitalised but it has some weaknesses in its reliance on overseas funding, though that has been reduced measurably with the increase in the Core Funding Ratio. There is more work to be done, especially around education, but we are moving in the right direction. This is just as well, since I for one, have no interest in waxing!