What is the interest rate on your savings account? If you don’t know, you can easily find out. Banks advertise their rates prominently. They want you to know what they’re offering. After all, the interest rate is the price a bank pays you for your savings.
Now ask yourself: What level of risk is your bank taking in order to generate these interest payments?
Banking is an inherently opaque industry. Even credit rating agencies struggle to reach a consensus when it comes to pricing bank risk. This is why the banking sector is subject to an additional layer of regulation, known as prudential regulation.
It is the Australian Prudential Regulatory Authority’s (APRA) job to examine the books of each Australian bank, assessing its overall risk of failure. We never learn the outcome of APRA’s investigations. APRA uses its statutory powers to prevent its assessments from becoming public. Instead, APRA prescribes minimum standards for banks, and helps a bank to restructure its assets if its risk of failure is too high.
The existing system of prudential regulation results in a “one size fits all” banking system. The regulator determines the maximum level of risk that a bank can carry. Because banks generate returns by taking risks, the regulator is effectively capping the interest rates available on savings accounts. As a consequence, there is little difference between the products being offered by Australia’s banks.
So, what is the alternative?
APRA should empower savers
In a recent article published in Economic Papers, Sinclair Davidson and I argue that APRA should use the information it gathers to empower depositors. We propose that APRA assign each bank a “Financial Stability Rating” (FSR) — a number out of 100 — based on its overall risk of failure. Under our proposal the FSR would be linked to the Deposit Insurance Scheme. In the event of a bank failure, the scheme would guarantee a percentage of each deposit equal to the bank’s FSR. If, for example, you had A$10,000 deposited in a bank with a rating of 87, $8,700 of your funds would be protected.
Our proposal links the returns a depositor receives to the risks a bank takes on the depositor’s behalf. If a bank wants to increase the interest rate it offers on deposits, it must increase its holdings of risky assets such as unsecured loans. In turn, this results in a lower FSR, meaning that depositors will lose a greater fraction of their saving in the event that the bank collapses. In this way, depositors are given an incentive to consider both sides of the risk-reward trade off when selecting a bank.
Of course, the incentives work both ways. Banks requires deposits. Therefore, our proposal provides banks with the incentive to tailor their products to match the preferences of depositors.
Depositors who are primarily concerned with the security of their savings will favour banks with high FSRs. In order to compete for these deposits banks would have to reduce their risk above the minimum standard dictated by the regulator. In effect, competing to be safe.
Of course, there will be other depositors who are willing to risk a portion of their savings in return for a higher interest rate. It’s likely some banks will structure their products to target these consumers. Overall, we would expect to see a greater variety of products on offer.
Benefits for all
Our proposal has a number of other advantages. First, it would likely reduce the cost of the deposit insurance scheme. On the one hand, banks competing to be safe are less likely to fail. On the other hand, the insurance scheme has reduced liability when a bank decides to carry a higher level of risk.
The scheme also has benefits for individuals and institutions who hold bonds or shares issued by a bank. Bondholders and shareholders are not protected by deposit insurance. Nevertheless, their investments are on the line if the bank fails. Providing investors with greater certainty about a bank’s behaviour would help financial and stock markets to better price the associated risk.
Finally, we believe our proposal would help free up credit to marginal borrowers. Our scheme allows banks to match depositors with a preference for high-risk/high-return investments, with borrowers with limited access to credit. In this way, we expect our proposal would promote the establishment and expansion of small businesses, in particular, with the consequent advantages to employment and economic growth.