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Should there be a bank deposit guarantee fee?

Deposit insurance has been mooted for Australian banks - but should we accept as given current banking structures which create too-big-to-fail banks? AAP

There is a growing chorus of support for introduction of a fee for the protection provided to bank deposits (up to the $250,000 cap) by the Financial Claims Scheme (or deposit insurance as it would be called elsewhere).

Reserve Bank of Australia Governor, Glenn Stevens, and NAB chief executive Cameron Clyne are among those recently reported as indicating it is worth considering.

It is, indeed, an issue worth considering – but probably more so on grounds of ensuring a level playing field (competitive neutrality) than on compensating taxpayers for risks borne by a bank failure. And in that regard its merits and design need to be considered carefully in full understanding of the effects of depositor and bank protection.

It is not just explicit deposit insurance which needs to be considered, but also the effect of implicit guarantees of (particularly large) banks – which governments are prone to bail out when likely to fail - and where the risks to taxpayer assume more relevance.

Consider first deposit insurance. Standard approaches to estimating the value to the bank (and thus appropriate fees) attempt to estimate a “fair” insurance premium of laying-off the risk of loss to insured depositors to the insurance fund or government.

But there are two problems with that. The first, somewhat peculiar to the Australian scheme, is that the risk of insuring some depositors is largely borne by other creditors (including uninsured depositors and bond holders) of the bank, rather than by the taxpayer or other banks (through imposition of an ex-post levy).

This arises because of depositor preference legislation. This leads to first ranking claim over the bank assets in insolvency being given to insured depositors and thus, when it pays out those depositors, APRA.

For Australian banks (but somewhat less so for building societies and credit unions given their balance sheet structures) it is highly unlikely that there would be insufficient assets to reimburse APRA – at the expense of lower recoveries by other creditors.

It could be argued that there is thus no net benefit to banks (and their shareholders) from this protection scheme because other uninsured creditors would demand accordingly higher returns on their funds to compensate for the higher risk. But that ignores two important aspects of bank protection arrangements.

The first is that the introduction of a deposit insurance scheme fundamentally changes the dynamics of banking. No longer are banks at risk of a “run” of retail depositors who are covered by insurance.

That is a major benefit, which is not incorporated into the standard “fair” pricing calculations. They take as a given input, banking sector dynamics after the introduction of insurance – rather than reflecting the benefits of its introduction.

The introduction of deposit insurance means that banks are able to adopt different portfolio structures and operational arrangements, in the knowledge that they are safe from the possible disruption of a retail depositor “run” on the bank – which could be sparked by either rumour or fact.

This is often linked to the “moral hazard” concern that deposit insurance prompts greater bank risk taking – but that is additional to the more general benefit and competitive advantage arising from safety from “runs”.

The second issue is that perceptions of implicit government guarantees of banks mean that uninsured creditors of banks won’t necessarily demand appropriately higher returns on their funds to compensate for risk. This provides a significant competitive advantage to banks over other financial institutions – and warrants consideration of some form of fee.

But how much should be fees for deposit insurance and implicit guarantees? The answer unclear – largely because banks are subject to a range of regulatory imposts such as capital and liquidity requirements. These are aimed at limiting risk-taking, ensuring that risks are appropriately borne by shareholders, and thus reducing the value of implicit (and explicit) guarantees.

Consequently, any setting of fees needs to be considered in the context of a broader perspective which attempts to balance the benefits of insurance with the costs imposed by regulation.

And one outcome of such a cost-benefit calculation is likely to be that appropriate fees could vary according to the type of institution. Larger fees might be appropriate for large, too-big-to-fail, banks.

But such conclusion assumes that we should accept as given current banking structures which create too-big-to-fail banks. That itself is something which a, now overdue, review of the financial system should consider.

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