Turning On a Dime: Crown Retail Deposit Guarantee Scheme
This is a New Zealand public policy case of a Minister of Finance responding to the recent
international financial crisis. On 12th October 2008 Dr Cullen used powers under the Public
Finance Act to establish the Crown Retail Deposit Scheme (Treasury 2008). The scheme covers
registered as well as unregistered banks and other financial institutions that issue debt securities to the public. As at 31 May 2009 it covered NZ$126.3 billion in liabilities (Treasury, 2009), and it has had a substantial impact on the distribution and flows and cost of funds to financial institutions (RBNZ, 2009).
The scheme marks a radical departure from longstanding public policy, violates many accepted
principles of good public policy, was unnecessary, exposes the Crown to massive contingent
liabilities, destroys the government's future credibility, and unfairly furthers the misconception that unregulated or lightly regulated banking systems are unstable.
Anti Deposit Insurance Policy
Previously there was an explicit anti deposit insurance / guarantee public policy, and public servants went to substantial lengths to build credibility to the claim the government would not rescue either depositors or financial institutions, even in the event of the failure of a bank that would be considered too big to close. The New Zealand public policy position was well explained by the RBNZ in 2003:
Unlike many countries, which have explicit depositor and investor protection objectives in the regulation of financial institutions and markets, New Zealand has eschewed this approach. There is no deposit insurance scheme in New Zealand and no explicit depositor protection objective in any financial sector regulation. ... Instead, the focus in New Zealand is on providing depositors and investors with reliable and timely information to assist them to make well-informed investment decisions ... Reflecting this, securities law and regulations are principally disclosure based.
But in the event of a financial crisis and a very large local bank failing, wouldn't there be serious
temptation for the government to rescue the bank and thereby its depositors? If the government is probably going to cave in to the pressure, depositors would realise this and have no incentive to discipline the bank. This time inconsistency and moral hazard problem was recognised and considered serious enough to warrant the development of a policy response: how could the government credibly promise to resolve the failure of a very large bank without socialising the losses? The RBNZ favoured a policy option called 'creditor recapitalisation' as a response, as outlined in 2001 by then Deputy Governor of the RBNZ Roderick M Carr:
A credible creditor recapitalisation option may avoid the need for and inefficiency induced by a deposit insurance regime. It may avoid the need for intrusive regulatory oversight. It seeks to protect the taxpayers interest. It may significantly reduce the public subsidy to depositors and other bank creditors arising from the put option they have not paid for and reduce the excess returns to bank shareholders from running an undercapitalised bank.
In December 2006, the government reviewed the regulation of non-bank deposit takers in a
discussion document and again eschewed depositor protection objectives in the proposed new
regulations:
44. The avoidance of a reference to depositor protection also reflects the view taken by Government that NBDT regulation, like other regulation in the financial sector, should not seek to eliminate risks for investors. ... it would be undesirable to seek to insulate depositors from loss in the event of a NBDT failure, given that this would excessively weaken depositors' incentives to monitor and exert discipline on NBDTs
Under this policy the New Zealand financial markets and institutions developed into a competitive financial system dominated by four highly credit rated, well capitalised, prudently managed, Australian owned banks (RBNZ, 2003).
The Recent Financial Crisis and Policy Change
The recent financial crisis began in late 2007, and caused the failure of several large banks and
other financial institutions overseas, notably Northern Rock (Feb 2008), AIG (Sept 2008), Lehman Brother (Sept 2008), and Citigroup (Nov 2008).
In New Zealand, however, no major financial institution and no registered banks (other than
Citigroup) faltered or failed. Many finance companies that provided loans considered too risky for the big banks failed. A textbook 'flight to quality' occurred in the financial sector, with funding
difficulties faced by lower quality institutions, and higher quality institutions receiving additional
retail funds (RBNZ, 2008). The big banks retained access to ample funding via selling assets to
their Australian parents and using Residential Mortgage Backed Securities (RMBS) created from
their loan books as collateral for borrowing from the RBNZ. The RBNZ reported in May 2009 that New Zealand banks were still able to access supposedly 'closed' offshore wholesale funding during the height of the crisis:
The major banks in particular rely heavily on offshore funding, a substantial fraction of which is raised by issuing short term debt in the US commercial paper (CP) market. ... this market has contracted significantly since the middle of 2007, with issuance slowing to a virtual standstill following the collapse of Lehman Brothers in September last year. While the New Zealand banks were generally able to issue CP during this period, maturities were typically very short and the cost was high by historical standards. (p 31).The same report shows that NZ banks' ratio of liquid assets to short term funding did not reduce
significantly during late 2008, indicating that no liquidity crisis occurred (p 33).
However on 12th October 2008, the Minister of Finance, without consultation or legislation,
introduced the Crown Retail Deposit Guarantee Scheme, retarding and reversing the market
adjustment that was occurring, with net flows of household funds going back into the risky finance companies they had been flowing out of in the previous 4 quarters (RBNZ, 2009).
Ethical Issues
The introduction of the scheme involves ethical issues such as:
- The role of the state in business: Should the state be involved in rescuing players in markets? Should it insulate or guarantee risks? Should it regulate to protect some participants?
- Is an unregulated or lightly regulated banking system unstable and in need of prudential regulation and deposit insurance?
- The policy making process: Should policy be made in haste? Should policy be submitted for public consultation? Should policy be made by way of legislation or by way of ministerial powers?
- Was the policy change necessary? Was it good policy? Was it equitable?
- Constitutional law: Should the state be restrained from taking actions of this kind?
New Zealand commercial public policy making and the principles and assumptions that underlie it are summarised in the Code of Good Regulatory Practice endorsed by Cabinet in 1997 (Treasury, 2008). The code adopts two ethical approaches: consideration of consequences (efficiency, effectiveness) and observance of absolute principles (transparency, clarity, equity), and includes policy making process, policy characteristics, and policy outcomes. New Zealand's success in maintaining a flexible and effective set of institutions and public policies have been recognised internationally, for example it is ranked as the world's second easiest place to do business (World Bank, 2009), and fifth most free economy (Heritage Foundation & WSJ, 2008), and first equal for avoiding corruption (Transparency International, 2008).
Critique of the Decision
The decision to introduce the scheme can be criticised on several levels:
- It expanded the role of the state in business significantly, in an area of business that was previously regarded, on the basis of sober public policy analysis, as properly the risk and return of private concerns. The consequences of the decision go beyond the socialisation of credit risk, to a more intrusive regulatory oversight of financial institutions as warned against by Carr, RBNZ, in 2001. It also goes against the Minimum Necessary Regulation, and Minimum Fiscal Impact guidelines of Code of Good Regulatory Practice.
- Dowd argued in Laissez faire Banking (1993), in addition to his primary thesis in favour of free banking, that 'Banking is 'different' from other industries, but not in a way that is relevant to public policy, except perhaps as far as the banking industry is itself the product of that policy' (p 2). In making the decision to rescue the industry, in addition to ignoring the good public policy reasons not to, Dr Cullen has furthered the misconception that it was necessary, and that the banking industry is a perpetual infant, always needing the guidance and at times aid.
- The policy making process used to make the decision was very poor. Had proper public consultation been undertaken, and the decision debated in and made by parliament, and had this process not been rushed, it is likely that the previous policy would have been maintained rather than overturned. Also breaches the Code: Public consultation should occur as widely as possible.
- As argued above, the scheme was not necessary to 'save' the NZ financial system (the big banks never faltered and had ample funding options), the scheme is poor policy (leading to the serious problems the previous policy was designed to avoid). The detailed design of the scheme can also be criticised on all three of the points Carr, RBNZ, 2001 listed as mitigating the deleterious effect of deposit insurance, with high coverage, no co-insurance, grossly actuarially unfair premiums (p 55). In regard to the premiums, this is an obvious inequity: rewarding imprudent investors and institutions and penalising prudent investors and institutions.
- The decision highlighted the shortcomings of the New Zealand constitution, as it failed to ensure good public policy was continued during crisis times.
decision has played well politically, with both government and opposition supporting it at the time and to date. I submit that this divergence between sober analysis of the public interest and political support in a crisis is perhaps one of the better arguments for increasing constitutional safeguards and removing crisis exceptions from them. While the judiciary dispenses justice though the heavens fall, the legislature and the executive seems prone to dispensing policy less appealing.
References
Dowd, K., 1993, Laissez Faire Banking, pp 1-2.
Heritage Foundation & WSJ, 2009, Index of Economic Freedom http://www.heritage.org/Index/
MED, 4 Dec 2006, Review of Financial Products and Providers: Non-Bank Deposit Takers
http://www.med.govt.nz/templates/MultipageDocumentTOC____22185.aspx
RBNZ, June 2001, RBNZ Bulletin, Vol. 64. No. 2., pp 50-60, Banking on Capital Punishment,
Roderick M Carr, Deputy Governor to the New Zealand Association of Economists, Christchurch,
27 June. http://www.rbnz.govt.nz/research/bulletin/1997_2001/2001jun64_2Carr27jun.pdf
RBNZ, Dec 2003, RBNZ Bulletin, Vol. 66 No. 4, New Zealand's financial sector regulation
http://www.rbnz.govt.nz/research/bulletin/2002_2006/2003dec66_4mortlock.pdf
RBNZ, May 2008, Financial Stability Report, p 29.
http://www.rbnz.govt.nz/finstab/fsreport/3311557.pdf
RBNZ, May 2009, Financial Stability Report, pp 27-37.
http://www.rbnz.govt.nz/finstab/fsreport/3631105.pdf
Transparency International, 2008, Corruption Perceptions Index
http://www.transparency.org/policy_research/surveys_indices/cpi
Treasury, 30 Oct 2008, Code of Good Regulatory Practice,
http://www.treasury.govt.nz/publications/guidance/regulatory/codepractice
Treasury, 3 July 2009, Financial Statements for the Government of New Zealand for the 11 months
ended 31 May 2009, Note 20
http://www.treasury.govt.nz/government/financialstatements/monthend/pdfs/fsgnz-11mthsmay09.pdf
World Bank, 2009, Doing Business 2010 http://doingbusiness.org/economyrankings/
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