90% guaranteed

The mainstream debate (ie not the one usually happening here) about government guarantees for bank deposits seems to hinge around two key variables.

  • How much of a bank account should get the guarantee.
  • Who should pay for the guarantee.

Turnbull proposed a guarantee that applied only to the first $100k of bank accounts. Rudd implemented a guarantee of an unlimited amount. Rudd then said that for large accounts the account holders should be made to pay for this compulsory insurance whilst Turnbull cried fowl.

Whilst I haven’t thought this through in detail it would seem that there is scope for debate around another variable. And that is the proportion of bank accounts that receives a guarantee. For instance instead of an explicit guarantee of 100% of bank deposits the government could have guaranteed 90% of the amount kept in a bank account. (Or 1% if it wanted to make explicit the fact that there wasn’t much of a guarantee from the government at all).  

What would be the upside and the downside of a government guarantee on bank accounts that was less than 100 percent?

28 thoughts on “90% guaranteed

  1. The first guarantee introduced was Ireland, which was because the government was concerned about the lack of interbank lending and/or about a run on deposits. Who knows why exactly? Anyway, only a 100% guarantee works because lenders and depositors are looking for capital preservation above all else and anything less than 100% would still see lenders refusing to lend and depositors stashing cash under matresses.

    Other European countries soon followed suit because they were concerned that cash would move from their banks to guaranteed Irish banks. Again, only 100% works because otherwise Ireland is more attractive and your banks still lose their capital.

    Would a guarantee of less than 100% work in Australia? Its not clear to me what the Australian government was trying to achieve by introducing the guarantee, so can’t say. Can capital move as easily from Australia to Europe? Surely not deposits. In any event, whatever they were trying to achieve, presumably only 100% works because its about ensuring lender confidence that their capital is safe in the face of potentially insolvent banks. Its not like lenders/depositors would take the view that close enough (90%) is good enough.

  2. Me – in the context of a crisis you are perhaps right that they would look silly putting a 90% guarantee when they wanted to bolster confidence. However longer term it seems to me that 90% would be better than 100%. Banks wouldn’t get a free lunch in terms of cheap funds.

  3. Me

    It’s a good point about capital movement of deposits between countries. I dont think it’s possible for an Australian resident to open a bank account in the UK, hence there would be no possibility of capital flight to foreign countries.

    I like the idea of the banks offering their depositors two types of account – govt guaranteed at a lower interest rate and no gtee witha higher rate. Therefore you can choose your level of risk and it still means that the more creditworthy banks can attract capital.

  4. There has been no comment on the more significant part of the guarantee: guarantee of wholesale market borrowings. Consider CBA, which is probably best off as far as deposits are concerned. As of 30 June it held $264 billion in deposits (although $41 billion of that was effectively wholesale money in CDs over $100,000). However that propped up loans and advances of $361 billion.

    So where did the additional $100 billion come from that it lent? A large chunk of it ($85 billion) is money that the bank borrowed by way of issuing bank bills, bonds and the like, $38 billion of it in foreign currencies and much of it short term.

    The guarantee on borrowings is intended to ensure, as far as the government can, that when the bank has to roll this debt over, it will be able to do so despite the current sticky state of international financial markets. Should the bank not, it would suffer a liquidity crisis and effectively collapse.

    The effect would be much the same as if retail depositors staged a run on the bank, but, as a number of commentators have noted, depositors were showing negligible nervousness, at least about the four major banks.

    However, given that the government guarantee on borrowings effectively raised the bank’s credit rating from AA to AAA, it would have been awkward to tell depositors that, although borrowings were government guaranteed, deposits were not.

    Balance sheet-wise, St George is in a less comfortable position even than CBA and has only an A credit rating. Thus it made sense for it to jump into the arms of Westpac.

  5. Guarantees by government on bank deposits is not implemented in order to open up lending between banks, despite the rhetoric of recent weeks. Deposit guarantees are implemented in order to forestall depositors ‘running’ a bank during uncertainty, whether they are suddenly uncertain about the bank’s ability to pay back the deposits or the economy’s uncertain performance.

    100% deposit insurance pays for depositors’ stability; 90% is 10% instability, and the rates will reflect that. As for only large depositors paying for everyone’s depositor’s insurance, what better way is there to get large depositors to ‘run’ a bank and yank their deposit?

  6. If the taxpayer assumes 90% of the risk and the depositor assumes 10% of the risk then I think this would be more than fair to the depositor. Especially given that the taxpayer can not take any action what so ever to mitigate the risks. The threat of a 10% capital loss would help ensure that banks that engage in risky investments don’t get as much of a free ride in terms of access to cheap funds.

  7. I should have thought that a fixed cap is better than a % guarantee on the theory that relatively small deposits are more likely to run that investors with very large deposits. If there is still a run then the govt can always nationalise. The 90% guarantee would still be destablising.

  8. Firstly, I doubt there actually was a crisis. For example, in today’s Australia Paul Kelly writes:

    “None of the big four Australian banks — NAB, Westpac, Commonwealth and ANZ — requested or lobbied for the unlimited deposit guarantee. Three of the majors confirmed this to The Australian yesterday while the fourth declined to rebut the point that no such request was made.

    In one sense this is scarcely a surprise, as funds at the time were flowing into the big banks. The preference of the Reserve Bank of Australia was for an alternative to the unlimited guarantee.

    This is confirmed by the email sent by governor Glenn Stevens the following Friday to Treasury chief Ken Henry saying in relation to the subsequent debate about a cap, “the lower, the better”.

    The Reserve Bank had been sceptical earlier about the Rudd Government’s pre-crisis decision to seek a $20,000 deposit guarantee.

    The bank was appalled at the consequences of the unlimited deposit guarantee. Stevens said “the more the guarantee is used, the bigger the problem elsewhere in the system”. Within days upwards of $25 billion had been frozen in market-based investments. Stevens put the issue bluntly: if investors wanted the guarantee, they should pay a fee for it.”

    Secondly, there is such a thing as risk-reward trade-off. An alternative to a blanket deposit guarantee is a range of deposits. The banks could offer 100% govt guaranteed bank deposits that attract small nominal interest rates, i.e. close to zero. Alternatively, they could offer non-govt guaranteed deposits with higher interest rates. In this way, depositors are free to choose the level of risk they are prepared to take.

    During the good times, people will opt for the non-guaranteed deposits and switch to the guaranteed deposits in the bad times.

  9. If people want their desposits guaranteed, banks could offer a savings account which is invested only in government bonds. Their investment would be as safe as the federal government (same with a desposit guarantee) and there would be no creation of moral hazard in the banking system. The cost of the lower risk would be exactly equal to the risk premium, and paid for by the people who benefit.

    The “100% secure” desposits would obviously receive a lower rate of interest.

    The other option for “100% secure” desposits would be putting your money in a safe. But instead of receiving interest, such people would probably have to pay a fee.

  10. Bonds have a maturity term and are not payable by the government on demand. Withdrawals from a bond backed account (esspecially so in a run) would entail the bank selling bonds and they don’t generally sell for face value. They sell with a price discount or premium according to prevailing interest rates compared with the bond interest rate. As such banks would not be able to significantly reduce the risk of a run by limiting their investment to government bonds.

    They could create 100% guaranteed accounts by investing in vault cash. Which is what Bird would have them do.

  11. The bond-backed deposit account wouldn’t be able to pay out all money at once… but because the underlying asset is guaranteed by the government there would be less incentive to have a run on the bank. And the money would always be there, it just wouldn’t always be liquid.

    So it’s a 100% guarantee of your money existing and a 99.9% guarantee of it existing in a liquid form.

  12. Yes but no guarantee of it’s value given than bonds don’t trade at face value. So there is still a risk of a capital loss. And without the capacity to diversify the assets base then such an account system would in fact be more risky that an account system that invested in a conservative diverisfied portfolio.

  13. The risk of capital loss would come from the risk in changing rates. Bonds don’t have to trade at face value for an investor to gain most of the interest on offer.

    Pooled investors actually have fairly simple, fairly effective methods of bond risk diversification, given the aims of their principals.

    Investors already can diversify. Multiple accounts, or multiple accounts globally in currencies with well known paired trades or correlated behaviour.

  14. “longer term it seems to me that 90% would be better than 100%”

    They’re not planning on keeping the guarantee long term are they? As someone above pointed out, it is a guarantee of deposits AND wholesale funding. It is an incredible situation where we have governments underwriting entire financial systems and it was a direct response to the incredible panic in September/October. Please tell me no one is considering this as a long term proposal? If so, small government advocates should rail against it hard.

    In relation to a “bond account”, depositors would still be unsecured creditors of the bank so their capital wouldn’t be any more secure.

  15. Ever been a secured or unsecured creditor (as an individual) of someone who simply can’t or won’t pay up?*

    How is Rudd going to fund $600 bln in liabilities?

    *Let’s repeal s 18 of the Privacy Act.

  16. Whould a tax holiday on interest earned on cash deposits in Australian Banks be a viable alternative to the guarantee without the moral hazard and the dead weight of taxation?

    The price signal might reduce depositor flight and increase deposits.

  17. Yes.

    Okay you mightn’t understand the first one. Bascially creditors can have it very easy if they want to be grubs. This is what the law dictates. Now the second point arises…despite the law, someone has to be willing to pay or be able to be forced to pay.

    The second question is simple to understand: how does Rudd expect to fund his guarantee if he needs to pay up? Where can any Australian Government get $600 bln on short notice? Our GDP is only about 1 trillion AUD p.a.

    Hi there Beyanite, welcome. I think there will be the same problem we have now – flight out of managed funds into banks. The problem didn’t exist before Rudd decided our safe banking system was somehow under threat.

  18. If you hold the bond to term then you will always get greater than 0% return on your money. If a bank offered to partially back deposits with short-term treasury bonds then they could offer 100% guarantee (or at least as good as the govt), a positive rate of inerest, and a near 100% promise of liquidity.

    Of course, the vault cash is another option, with 100% promise of liquidity… but a negative rate of interest.

  19. don’t worry about the deposit guarantee, it seems the government is now guaranteeing the provision of child care!

  20. John – the problem is that it is all very well for a bank to “partially back deposits with short-term treasury bonds”, but if other parts of the bank are running off raising wholesale funds and purchasing over-priced mortgage backed securities, then when those mortgaged backed securities start defaulting, the short-term treasuries are as much up for grabs by the wholesale lenders as they are the depositors.

    A savings account is a simple debtor-creditor relationship between banker and customer. If you want to ring-fence certain assets to certain liabilities, a more complex arrangement is needed.

  21. Mark – without wanting to sound obtuse, I still don’t get your questions.

    I said that a “bond account” wouldn’t work because the depositors would just be unsecured creditors – i.e. they would not have direct recourse against the bonds, so they are not going to receive 100% of their principal back. I don’t understand what you’re getting at. Obviously, if secured assets are worth less than the secured debt, a secured creditor is also likely to receive less than 100% of its debt… is that your point?

    I don’t know how Rudd is going to fund a $600bn liability, but I don’t understand why you’re asking me that… I never said the guarantee was a good idea, only that now that its in place it should certainly not remain long term.

  22. I doubt that “ring-fence” would be hard. Banks already offer a variety of products, including managed funds. This would just be a low-return, low-risk, high-liquidity managed fund that invests on only two assets (cash & bonds).

    Alternatively, separate institutions could set up “bond-backed deposit accounts” and go into competition with the banks as a “low-risk bank”.

    Perhaps somebody would even set up a “Bird Bank” and offer only vault cash. Though even this wouldn’t be 100% secure. Banks can be robbed. And insurance companies can go broke.

    I believe “low-risk accounts” (as above) would be the natural market outcome, but it is prevented by the implicit (and now explicit) deposit guarantee, which leads to moral hazard.

  23. Well me, I guess I can sum it up like this – the guarantee is very risky in terms of the consequences that may arise so it should be scrapped immediately – not in the near future, but now.

    Contractually, couldn’t the FI could give them secured creditor status?

    As an aside, I don’t know why people are so down on the Liberty Dollar.

  24. I wonder if the Government could have offered no guarantee but have required each bank to make a guarantee of its own. Each bank would guarantee an amount that they could afford. The banks that couldn’t afford to offer the same guarantees as their compeitors would have been forced to recapitalise or face bank runs. The Government would undertake to prosecute bank boards for criminal fraud if they made a guarantee they later couldn’t deliver on.

Comments are closed.