This article originally appeared in the NZ Herald.

The Reserve Bank’s poor oversight of CBL Insurance has raised questions about the security of our banks, which are also regulated by the central bank.

How safe are New Zealand’s banks? Does the Reserve Bank have the expertise to deal with a troubled bank? What happens if a New Zealand bank goes bust?

A major New Zealand bank failure is highly unlikely, but it is worth knowing what happens to your money if a domestic bank fails.

A 2014 Financial Markets Authority survey revealed that 75 per cent of respondents believed their NZ bank deposits were guaranteed.

These respondents were essentially wrong. Thirty three of the 35 OECD countries have deposit insurance or government guarantees, but New Zealand and Israel are the two notable exceptions.

In other words, all or part of bank deposits are insured or guaranteed in most countries but New Zealand bank depositors are not shielded from losses when a bank fails.

The accompanying table contains the details of bank guarantees in several countries, which can be summarised as follows.

Australia: Depositors’ preference is enshrined in the Australian Banking Act 1959, which requires that Australian depositors are first in line to recover funds from the assets of a failed authorised deposit-taking institution.

Deposits held across the Tasman in banks, building societies and credit unions are guaranteed by the Australian Government, up to a maximum of A$250,000.

Canada: The Canada Deposit Insurance Corporation, a Canadian Government entity, guarantees deposits up to C$100,000 by resident, non-resident and non-Canadian citizens if funds are held in eligible deposits.

France: This scheme includes all deposits, including those in all European and non-European currencies.

Germany: Four German banking associations have supplementary voluntary guarantee schemes, in addition to the state’s €100,000 guarantee.

Norway: The Norwegian Banks’ Guarantee Fund, which has one of the highest guarantees, covers deposits up to NOK2 million ($360,000) per deposit per member bank.

New Zealand: A New Zealand Retail Deposit Guarantee Scheme was introduced in October 2008, but terminated in December 2011. Unlike other countries, it was an open-ended scheme with investors in nine covered finance companies receiving their money back. The largest payout was in relation to South Canterbury Finance, where depositors received $1.6 billion from the Crown.

Britain / US: The UK’s Financial Services Scheme, formed in 2001, guarantees up to £85,000, while the Federal Deposit Insurance Corporation in the US, established in 1933, guarantees US$250,000 per depositor, per insured bank.

Depositor protection has risen dramatically for two main reasons.

Between 1980 and 1995, more than 1600 US banks went bust or received financial assistance.

In addition, there has been a substantial increase in bank privatisations, particularly in former communist countries, and depositors have more confidence in these banks if all or part of their money is guaranteed.

There has been widespread discussion on the pros and cons of deposit insurance and bank guarantees but it hasn’t been a major issue for debate in this country. This is surprising, as New Zealand depositors receive minimal protection and our current situation favours the established Australian-owned banks because it is more difficult to start up a new bank without some form of deposit insurance or guarantee.

The main argument against deposit insurance is the issue called “moral hazard”. This refers to the incentive for insured banks to make riskier loans, partly because insured depositors have little incentive to monitor the risks taken by their banks.

New Zealand doesn’t have deposit insurance or bank guarantees but the Reserve Bank has introduced a system called Open Banking Resolution (OBR).

Under OBR, the Reserve Bank will undertake an initial assessment of the health of a troubled bank.

Following this assessment, the procedure is as follows:

  • The Reserve Bank may make a recommendation to the Minister of Finance that the bank be placed under statutory management.
  • If the Minister of Finance decides to go down the OBR path, then a proportion of the bank’s funds, including individual deposits, are frozen to cover the estimated losses. The bank opens for business the next day, with depositors able to get access to their unfrozen funds, although individuals with term deposits will have to wait until these mature.
  • These unfrozen funds are subject to a government guarantee.

The OBR process allows a bank to close temporarily and then reopen while a long-term solution to its problems is developed. This contrasts with the finance company failures a decade ago, when all funds were immediately frozen and depositors had to wait a long time before they got any money back.

Frozen funds are determined on the following basis:

  • The OBR has been designed to ensure the owners and shareholders bear 100 per cent of the initial loss due to a bank failure.
  • Subordinated creditors also take a 100 per cent haircut after that.
  • The remaining frozen funds are allocated proportionally among unsecured creditors, mainly domestic sourced deposits and wholesale deposits from large international financial institutions.

If it was determined that 20 per cent of a bank’s assets would have to be written off, then the impact on the liabilities side of the balance sheet would look something like this.

All equity and subordinated creditors’ funds, normally around 8 per cent and 2 per cent respectively, would be frozen.

None of the amount owed to secured and preferred creditors, which might be around 10 per cent of total liabilities, would be frozen.

The remaining amount required to be frozen would be divided equally among unsecured creditors, including domestic depositors.

Thus, an Australian with A$25,000 deposited in an Australian bank would have it all guaranteed.

By contrast, a New Zealander with $25,000 deposited in a fully owned subsidiary of an Australian bank could see $3000 or more of his or her $25,000 deposit frozen.

The frozen funds figure will depend on the amount of bank loans required to be written off.

The OBR system has been introduced in New Zealand because it reduces “the pressure for government to provide a bail-out to a failed bank”. The Reserve Bank goes on to state that “the OBR might also help to strengthen incentives on bank management to operate in a more prudent manner, and on creditors to provide greater external scrutiny, helping to mitigate the moral hazard concerns that arise when an assumption of implicit government support prevails”.

In theory, the OBR has great merit because a failed bank could be open within 24 hours with the unfrozen funds available and subject to a government guarantee.

However, the Reserve Bank and Ministry of Finance would probably freeze more funds than necessary, to ensure that this government guarantee isn’t called on. This could create considerable depositor discontent.

But the main issue is the Reserve Bank’s ability to carry out a proper process, to make quick and decisive decisions and to ensure that the investing public, both depositors and shareholders, are fully informed.

The CBL Insurance debacle raises serious questions about the Reserve Bank’s ability to effectively execute its regulatory obligations. A major bank failure, which is highly unlikely but does happen occasionally, would put the Reserve Bank under enormous pressure.

Recent comments from a senior Reserve Bank employee indicate that the regulator doesn’t believe that keeping sharemarket investors fully informed is one of its objectives. This attitude would be a disaster if one of the major Australian owned domestic banks had problems in New Zealand.

For further analysis on the OBR and safety of bank deposits, please see our recent blog post here