Ng, Keith; Brown, Kym; Avram, Katherine J --- "Safety net. Australian banks" [2007] MonashBusRw 33; (2007) 3(2) Monash Business Review 7

Safety net
Australian banks

Keith Ng, Kym Brown, Katherine J Avram

Bankers say no thanks, supporters hope it will liberate Australia’s financial system and the financial press sit somewhere in the middle.

Deposit insurance is a guarantee that if a bank or insurer goes down, insured depositors get something back. There are two types of insurance: explicit and implicit. Explicit deposit insurance is an unequivocal agreement that bank deposits or insurance policies are protected up to a limit. With implicit deposit insurance the public remain uncertain if the Government will step in and pay out deposit holders in the case of corporate failure. Australia has an implicit deposit insurance system although for political reasons most governments have eventually jumped in after a collapse such as in the case of Pyramid Building Society in Geelong and HIH Insurance.

A new proposed scheme for retail depositors only put forward by the Council of Financial Regulators (CFR) wants the Government to provide a certain percentage (90 per cent and up) of a prescribed amount (proposed $20,000) of the money lost. When the bank is fully wound up, the liquidator reimburses the Government and if there’s insufficient funds, other surviving authorised deposit-taking institutions (ADIs) would be levied.

At the moment, Australian depositors are protected by the ‘depositor priority’ rule or provision contained within the Banking Act 1959. This states that, “depositors in Australia have first claim on the assets of an ADI in Australia should it be unable to meet its obligation or should it suspend payment”. To support depositors’ interests, the Banking Act requires ADIs that take Australian retail deposits to hold assets here equal to their deposit liabilities.

Some worthy facets of the CFR insurance scheme are that it helps protect small depositors and encourages them to save; it stabilises the banking system; and it forces individuals with deposits over the stipulated limit to more closely monitor their bank’s activities.

However, the proposal has its problems. The insurance could cause banks and depositors to become more complacent. It may also create a ‘moral hazard’ – both ADIs and insured depositors may adopt more risktaking activities to maximise their returns knowing their funds are covered. The adverse effects of this could spread throughout the banking sector. However, this moral hazard is minimised by the CFR recommendations that do not entirely eliminate the risk for both ADIs and depositors.

A key difference between the current implicit and the proposed explicit system is how they are funded. The current system is taxpayer funded, but any excesses not covered under the proposed explicit system by asset sale fall on the surviving institutions in the same pool as the failing institution. Rather than obtaining funding from all financial institutions and general and life insurance companies when, say, a credit union fails, the scheme limits the pool source. If a failure occurred in one sector such as a credit union, only the ADI funding pool is liable.

The CFR has proposed an ex post-funding arrangement based on other institutions in each pool. The levy will be based on surviving institutions’ share of total insured deposits. The other option for explicit deposit insurance would be a pre-funded arrangement where institutions pay a levy each year to add to the pool.

How much each institution should contribute is another contentious issue. Theoretically, riskier firms should contribute more, but the CFR applies funding levies based on the insurance deposit base as a percentage of the total pool of insured funds. This means that the lower risk banks will be required to pay the deposit insurance costs incurred when a high risk institution fails. Effectively, the costs of deposit insurance fall more heavily on the low risk institutions – probably one good reason why the banks aren’t over the moon about it.

The use of post-funding means that funds are only raised as required. It could be argued that the riskiest players should bear a higher level of liabilities, but APRA’s assessment of risk via its Probability and Impact Rating Systems decrees that the regulatory requirements of each institution not be publicly disclosed so as not to create panic in the market. A risk-based levy approach is more appropriate for a pre-funded scheme where risky behaviour leads to higher premiums. Deposit insurance will cost money. The CFR proposal wants the banks to fund it and there are no premiums to be paid on an ongoing basis. The CFR proposal is a good way to implement an explicit Australian deposit insurance scheme that will minimise liquidity issues and uncertainty for private depositors and policy holders and limit moral hazard.

Incentive to monitor the behaviour of players will shift from individual small holders and policyholders to industry competitors. A trade-off of the funding of the scheme is that it is based on insured deposits, rather than the riskiness of insured institutions. It’s fair enough that excessive risk should be afforded higher regulatory requirements but rather than make the market aware of the more risky players and perhaps incite panic, the CFR funding system is based on the size of insured deposits. In conclusion, the CFR explicit deposit insurance proposal delivers stability and efficiency to the Australian financial system, without being overly burdensome to surviving institutions.

MBR subscribers: to view full academic paper email [e-mail]

Public access: www.mbr.monash.edu/full-papers.php (six months embargo applies)

Cite this article as

Ng, Keith; Brown, Kym; Avram, Katherine J. 'Safety net'. Monash Business Review. 2007.; Monash University ePress: Victoria, Australia. http://www.epress.monash.edu.au/. : 6–9. DOI:10.2104/mbr07033

About the authors

Keith Ng

Keith Ng studies BBus (Accounting)/BBus (Banking and Finance) at Monash University.

Kym Brown

Kym Brown is a Lecturer in banking with the Department of Accounting and Finance, Monash University.

Katherine J Avram

Katherine J. Avram is a Senior Lecturer with the Department of Accounting and Finance, Monash University.