Deposit Insurance – Getting the Financial Claims Scheme Settled

Posted on June 8, 2011
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Insurance, Policy, Publications | Leave a Comment

FRDP 2011-03
June 5, 2011

In this Australian Centre for Financial Studies Financial Regulation Discussion Paper, Professor Kevin Davis reviews the proposed changes to the Financial Claims Scheme which were released in May 2011. He argues that the absence of an ex-ante risk based insurance fee is justified given the “closed resolution” nature of the scheme, and the priority given to APRA in the unlikely event that the scheme is activated. However, the existence of the scheme arguably generates competitive benefits for ADIs, relative to other non-ADIs competing for retail funds, due to perceptions of greater safety. Whether such benefits are offset by costs to ADIs from prudential regulation, or whether some fee is warranted on competitive neutrality grounds is an unanswered question.

The only surprise in the proposed changes to the Financial Claims Scheme (FCS) is why the Government took so long to reach, and announce, those plans. The existing cap of $1 million had to be reviewed by October 2011, and procrastination has done little other than add the slight complexity of how to deal with term deposits which run over that date.

Most of the suggestions by the Council of Financial Regulators for changes to the FCS are relatively straightforward and uncontroversial. But the proposed size of the cap and the financing of the scheme will no doubt evoke debate.

The straightforward changes include the following.

First, deposits in foreign branches of Australian banks are not covered by the scheme. International practice varies on this score, but the recent Icelandic experience cautions against countries taking on such exposures. More generally, international regulatory pressures seem likely to lead to most international expansion being by way of separately capitalized subsidiaries (covered by the host country deposit insurance scheme). In that case, deposit insurance arrangements for foreign branches become a non-issue.

Second, coverage will not apply to foreign currency deposits. Individuals holding such deposits are presumably not unsophisticated investors whom the scheme is designed to protect.

Third, foreign bank branches will not be covered, unlike Australian subsidiaries of foreign banks which are incorporated, separately capitalized and supervised by APRA). Since their licenses are premised on them not dealing with typical retail customers (they are not permitted to accept deposit accounts with initial balances of less than $250,000), exclusion from a scheme which involves a cap on insured deposits of no greater than that amount is again, a non-issue.

Fourth, since the insured cap is meant to apply to total deposits of an individual at one bank, a coverage issue arises when an agent (such as a trustee) operates one account on behalf of a number of individuals. The proposals, sensibly, advocate “looking through” the account to identify the ultimate owners, with the proposed cap applying to each.

The first issue which will generate debate relates to the proposed size of the cap. Perhaps the most surprising aspect of the debate will be the absence of proposals by banks and other ADIs to lower the cap on insured deposits below the $100,000 to $250,000 range suggested by the Council of Financial Regulators.

My how times change! When the FCS was originally mooted with a suggested cap of $50,000, the banks lobbied hard to have the cap reduced to $20,000. In the event, the Global Financial Crisis (GFC) intervened and the scheme was introduced with a cap of $1 million. At $50,000, almost all retail depositors are fully covered, but the GFC has led to a general increase in coverage levels internationally, and the proposed range is not inconsistent with that found elsewhere.

Smaller institutions, such as credit unions, can be expected to lobby for retention of the $1 million cap. Explicit government protection removes some of the competitive disadvantage they feel they face from the perceived implicit government protection which, it can be argued, the large banks gain from their size. Since no up front fees are proposed as part of the scheme, the larger the cap the better from their perspective.

The issue of fees will no doubt generate some debate. An ex-post funding approach is to be maintained, whereby levies on other ADIs would be made should APRA pay out depositors of a failed ADI and not recoup those funds from the realization of the failed ADI’s assets.

Some will argue that ex-post funding of the scheme is inappropriate, due to moral hazard concerns, and that an ex-ante risk-based fee scheme should be used. These arguments have limited weight given the specific nature of the scheme.

First, the moral hazard concern is that depositor protection reduces depositor monitoring of bank risk taking and enables excessive risk taking by ADIs without the penalty of needing to pay higher deposit interest rates reflecting that risk.

Really! The notion that retail depositors have the expertise and ability to assess the riskiness of even small ADIs is laughable. Even sophisticated analysts who might provide such information to depositors do not have a good track record in this regard. Risk-based capital requirements and APRA supervision (and its flexibility to adjust capital (and liquidity) requirements for individual ADIs) are one reason to think that moral hazard concerns are not a major issue. Another is that market discipline by wholesale providers of funds to banks, who are not covered by the scheme, is unaffected by the nature of the deposit insurance arrangements. Arrangements which create moral hazard need to be avoided, but this is not one of them. In fact, it can be argued that since the alternative to an explicit, limited cap, insurance scheme is depositor perceptions of a complete implicit government guarantee, such a scheme reduces moral hazard.

The main effects of protection are to reduce uninformed runs and panics, and enable ADIs to raise funds at “risk-free” interest rates. Hence this is clearly of benefit to those ADIs covered by the scheme, and to which we shall return shortly.

The second concern – that an ex-ante risk-based fee scheme is needed – ignores how the FCS operates.

First, it is a closed resolution scheme, meaning that it only comes into operation when APRA applies to wind up an ADI or, where under the revised proposals, a statutory manager has been appointed and all hope lost of an alternative to winding-up).

Who believes that APRA and the Government will ever let a bank or other ADI, fail in that way, rather than finding some method of open resolution for troubled institutions such as a take-over or merger? In other words, the FCS book of procedures is highly unlikely to ever be taken off the shelf and the FCS activated.

Second, even if the scheme is activated, it is extremely unlikely that ex-post levies on other institutions will be necessary. The reason is that, upon failure, APRA pays out insured depositors and then stands at the very front of the queue for compensation from the liquidation of the failed ADI’s assets. It is the uninsured deposits and other claimants who lose. Only if total assets were not enough to cover the insured deposits would APRA need to impose a levy.

In general, this is extremely unlikely – although it obviously depends on the size of the cap and the structure of the ADI’s balance sheet. If all deposits were insured (ie. an unlimited cap) and there were no other creditors, then APRA could face a shortfall. But that is clearly not the case with larger banks who have substantial other funding sources. A modest cap ($100,000 – 250,000) would likely ensure that smaller ADIs have a buffer of uninsured deposits which bear the losses.

(It might be argued that not giving APRA priority in liquidation would increase APRA’s incentive to resolve troubled institutions before a liquidation situation is reached. In practice, the reputational cost to APRA of not monitoring ADI capital positions and acting rapidly enough to prevent a liquidation situation would appear to make the priority issue one of second-order importance).   

So, a risk-based ex-ante fee has little to justify it. But there is, arguably, a case for some form of charge as a requirement of competitive neutrality between ADIs and other institutions seeking to raise funds from retail customers. Because the FCS provides an aura of government protection for retail deposits not available to other financial institutions, ADIs benefit in two ways. One is the reduced likelihood of depositor runs which enables them to undertake greater liquidity creation than would otherwise be the case (ie. by using short term deposits to make long term loans while holding lower levels of liquid assets). The second benefit is the ability to raise retail funds at lower interest cost than their non-ADI competitors.

Banks and other ADIs will no doubt argue that they do already pay via capital and  liquidity requirements and through other regulation and supervision imposts. That may be so, but whether it is on balance adequate to offset the competitive advantages of explicit and implicit government protection is far from obvious. Whether the cap should be set at the proposed lower end of $100,000 or the upper end of $250,000 should perhaps be considered primarily in the context of how much it distorts competition in the market for retail funds between ADIs and other non-prudentially regulated institutions.

On the other hand, if individuals perceive that their deposits in ADIs have an implicit government guarantee regardless of their size, the size of the cap is largely irrelevant. It will be interesting to see if researchers can answer that question about perceptions by analysis of the behavior of depositors with $1 million or more over the last few years.

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies and Professor of Finance, University of Melbourne.
info@australiancentre.com.au

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The Financial Regulation Discussion Paper Series provides independent analysis and commentary on current issues in Financial Regulation with the objective of promoting constructive dialogue among academics, industry practitioners, policymakers and regulators and contributing to excellence in Australian financial system regulation. More in this series

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Basel III Liquidity Options

Posted on June 2, 2011
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Policy, Publications | Leave a Comment

FRDP 2011-02
May 28, 2011

In this ACFS Discussion Paper, Professor Kevin Davis examines the new Basel Liquidity Requirements announced at the end of 2010, focusing primarily on the liquidity coverage ratio (LCR) requirement. The underlying philosophy of the approach can be questioned, partly because it aims to deal with both systemic stress and individual bank stress using the one policy instrument. The “Australian solution” to the shortage of high quality liquid assets (HQLA), involving a fee based liquidity facility at the Reserve Bank, also raises a number of tricky questions about determination of an appropriate fee and may require a review of system wide liquidity management arrangements.  While some details remain to be determined, and the implementation date is relatively long distant, the impact on Australian banks and the financial market is likely to be substantial.

It is generally accepted that the forthcoming introduction of liquidity requirements as part of Basel III^[1] poses significant issues for Australian banks. In particular, there is a shortage of government debt available to be held to enable compliance with the Liquidity Coverage Ratio (LCR) requirement. The proposed “Australian solution” to this problem changes the approach to ensuring liquidity crises are avoided in a subtle, but significant, way, and may have broader implications for system-wide cash management arrangements. The Net Stable Funding Ratio (NSFR) requirement also has the potential to affect the structural development of Australian financial markets, given the current high reliance on overseas wholesale debt markets.

The Basel III LCR and NSFR requirements have been introduced as one response to the Global Financial Crisis experience in which banks, worldwide, experienced liquidity crises. Holdings of marketable private sector securities turned out to be not very marketable, and lines of credit and short term funding dried up. A vicious cycle of asset sales to meet funding shortages led to asset price declines, inducing collateral and margin calls and further funding problems.

That experience demonstrates the third of the problems associated with liquidity. The first problem is that liquidity is hard to define, although most analysts would point to a liquid asset as being one which can be converted into cash (the ultimate liquid asset) quickly and without risk of significant loss of market value. Second, it is even harder to measure. And third, it is likely to disappear just when it is needed most. It is not an inherent, immutable property of a financial asset, but one subject to the fallacy of composition. An asset may be liquid for any individual holder, but not if all holders are attempting to use that property simultaneously.

The Basel Committee^[2] has defined bank liquidity as follows. “Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses.” Such liquidity risk arises from the key role of banks as liquidity providers by funding longer term assets with shorter term (often at call) liabilities.

Their approach has been to announce the gradual introduction of two minimum requirements, one aimed at short-term crisis situations and the other focused on longer term funding.^[3] Although not strongly emphasized, the former focuses primarily on system wide liquidity crises (reflected in the use of a stressed scenario involving “a combined idiosyncratic and market-wide shock” (bcbs188, para 17) and the latter on individual bank difficulties involving “an extended firm-specific stress scenario” (bcbs188, para 125).

The LCR Requirement

The LCR requires banks to hold an amount of high quality liquid assets (HQLA) sufficient to enable the bank to cope with fund outflows over a one month stress period. The scenario envisaged for cash outflows draws on the experience of the Global Financial Crisis, and assigns varying “run-off” factors to different classes of funding, allows for limited inflows of funds (such as from contractual repayments on loans), and assumes limited outflows of funds associated with the need to maintain some level of lending and credit extensions. Given the complexity of bank operations, including collateralized funding, off-balance sheet activities and derivatives transactions, there is a long list of categories of transactions for which quantitative assumptions about run-off factors to derive the denominator of the LCR must be made.

Because avoiding asset price fire-sale declines is critical, only assets whose price is not sensitive to credit risk concerns are suitable for inclusion in HQLA (the numerator of LCR). The Basel Committee adopts a two tier approach to the LCR with level one assets (essentially sovereign debt and Central Bank liabilities) being required to account for at least 60 per cent of HQLA. Level 2 assets can include highly rated (AA- or better) corporate (non financial institution) and covered bonds and some other assets (with a 15 per cent haircut to market value applied).

The Basel Committee also suggests that HQLA should be eligible for use as collateral in accessing Central Bank liquidity facilities. Because of the system-wide stress scenario used, securities issued by other banks or financial institutions are not included in HQLA because these would be likely to be facing losses in market value.

Ultimately, these criteria for eligibility mean that Australian government and semi-government debt have been designated by the Australian authorities as the only currently available assets meeting the LCR.^[4] While the Reserve Bank accepts residential mortgage backed securities as collateral for repurchase agreements, these are issued by other financial institutions. Similarly, despite a large Kangaroo Bond market (AUD securities issued in Australia by foreign entities), the depth of the secondary market in these securities, and demonstrated resilience, is deemed inadequate. While the Federal Government has recently announced plans to allow limited issuance of covered bonds, it will (hopefully) be some time before there is any evidence of how prices of such securities will cope in a time of stress (and their consequent suitability as level 2 HQLA).

The Australian dilemma is that, even with a shift of the government budget into deficit for some foreseeable future, past years of surpluses mean that there is unlikely to be sufficient Federal or State government debt to meet bank LCR demands. While, in aggregate, there may be enough debt on issue, the demands of other fixed interest investors (both domestic and foreign) mean that there will be strong competition – pushing government yields down. Good for the government, but not for the holders!

The response has been to obtain Basel approval for the “Australian solution” (also relevant for a few other countries in good fiscal shape). This involves banks being able to meet their LCR “gap” by inclusion of liquidity facilities which they obtain, for a “fair” fee from the RBA.

An Assessment of the LCR Requirement

The approach adopted places the onus for liquidity insurance upon the banking sector and private financial markets. The LCR approach does not envisage the banking system relying (at least initially) upon the safety valve of RBA liquidity provision via repurchase agreements etc. The logic of the approach can be questioned, in so far as it applies to system wide crisis scenarios rather than individual bank difficulties.

Consider a situation in which a liquidity crisis occurs and banks respond by selling their holdings of government securities. Such widespread action will push the prices of those securities down and their yields up, which is unlikely to be a desirable outcome in such a situation from the perspective of the RBA. Consequently, there is likely to be RBA operations in the cash market to inject liquidity by purchasing government debt or by repurchase agreements based on those or other eligible securities.

Consequently, the merits of an approach which assumes that the market can ensure enough liquidity in a crisis situation seems contradictory to the likely outcome, when the only ultimate provider of liquidity – the Central Bank – is likely to have to act. To the extent that this is the case, the exclusion of other repo-eligible securities from the LCR calculation can be questioned.

To the extent that the LCR is aimed at ensuring individual bank liquidity adequacy in a time of individual stress, there are also some questions which should be posed. First, are requirements based on a system-wide stress scenario appropriate? Second, the exclusion of a range of private sector assets from the calculation seems less warranted since their values would be little impacted by sales by one bank only.

The dilemma here is that the LCR appears to be one instrument aimed at achieving two objectives – one being individual bank liquidity adequacy in a single-name stress situation and the other being system wide liquidity adequacy in a generalized crisis scenario. A long standing tenet of policy formulation is that at least as many instruments are required as there are objectives if those objectives are to be fully met, rather than being constrained by a trade-off.

A number of other important issues arise from the planned implementation of the LCR.

Deposit Insurance Coverage:
The stress scenario gives a very low “run-off” rate to insured deposits. The more is insured deposit funding, the lower will be the hypothetical scenario cash outflow and thus the lower required HQLA holdings. The higher is the “cap” decided upon for the Financial Claims Scheme (currently $1 million and to be re-set by October 2011) the higher will be the proportion of deposits which fall into this category.

The Australian solution:
There is a fundamental difference in the underlying philosophy implied by the solution to a shortage of HQLA of allowing banks to fill a LCR gap through contracted liquidity facilities at the RBA. Specifically, it allows for liquidity requirements to be met partially by having in place arrangements for tapping this RBA liquidity safety valve – rather than requiring liquidity protection to be purely by way of bank sales of liquid assets into the private markets.

The ultimate, aggregate, outcome may not be too different. If instead, in the absence of that facility, all banks are unloading government securities in a crisis and pushing prices down and yields up, the RBA may be compelled to step into the market as a buyer to meet its interest rate targets.^[5] Aggregate liquidity would be increased, as would have been the case where the liquidity facility approach applied. While the adjustment process may be different, it is not apparent that the outcome would be different to a situation where repo-eligible securities are allowed to be counted to meet the LCR.

Where an individual bank faces a “name” crisis, it may be able to sell non HQLA assets without creating “fire sale” conditions. Consequently, the need for that bank to tap the liquidity facility is likely to be reduced, and the likelihood of RBA liquidity injection is reduced. But nevertheless, there is a fundamental change away from requiring basic liquidity protection solely by private provision.

This raises two possible alternatives. One is that other private sector securities which are “repo-eligible” at the RBA could be included in LCR eligible assets. The Basel Committee provides for the option for “level 2” assets to be included with a minimum 15 per cent haircut, and that haircut could be increased if it was thought appropriate to allow some available assets (mortgage backed securities, Kangaroo bonds) to count as level 2 assets.

Another option is that banks could build up their holdings of Exchange Settlement Accounts at the RBA – because these also count towards the LCR. Currently the RBA pays interest on these at 25 basis points below the target cash rate, and the banks minimize ESA balances accordingly. This raises the question of the pricing of the proposed liquidity facility.

Pricing of the RBA liquidity facility

The Australian solution requires that a fee be set for the liquidity facility which is “fair” – in the sense that there is no benefit/cost from using the facility (and holding eligible non-HQLA assets as potential collateral) relative to holding additional HQLA to meet the LCR requirement. There are two fundamental problems here. One is that the counterfactual involves setting a fee which is related to the credit-risk adjusted yield of additional holdings of level 1 and 2 HQLA, when there are none of the latter for which a yield is available.

The second problem is that a fundamental simultaneity problem exists, as follows. The reason for the safety valve facility is that the cost to banks of acquiring HQLA beyond some level is seen as prohibitive, given the stock available. As banks attempt to increase their holdings of government debt, their demand will drive down its yield relative to other investments. Wherever the liquidity facility fee is set will affect the relative use of the liquidity requirement versus holding HQLA, with the latter in turn affecting the cost to banks of using HQLA. The Figure below illustrates. The opportunity cost to banks of holding more government debt (the additional risk adjusted yield foregone on alternative private debt) is shown as increasing in their holdings of HQLA (because the higher bank demand for government debt drives down its relative yield). If the liquidity facility fee is set at Fee_a, HQLA holdings will be at HQLA_a, if it is set at Fee_b the holdings will be at HQLA_b etc. Thus there is no unique fee level.

Exchange Settlement Account Arrangements and the Liquidity Facility Fee

A further complicating feature arises from the ability of banks to use Exchange Settlement Account (ESA) balances to meet the LCR requirement. Currently the RBA pays 25 basis points below the cash rate, and banks manage their liquidity to keep minimal ESA holdings (lending surplus funds to other banks overnight at the cash rate). Conceivably, and ignoring the simultaneity discussed above, it may not be possible for the RBA to always charge a sufficiently low fee for its liquidity facility so as to make that more attractive than building up ESA balances.

Consider, for example, the situation where a bank holds repo-eligible RMBS to support the liquidity facility.  Because there is a haircut given to level 2 assets of at least 15 per cent, $100 of HQLA would require (say) $120 of holdings of level 2 assets. The fee for the liquidity facility should thus be for a facility of $120 and would reduce the net return on the $120 of repo-eligible assets backing that to of a government bond rate equivalent. The consideration for the bank is whether it would prefer to hold $120 of assets earning (net of the liquidity facility fee) the government bond rate compared to the alternative of $100 in its ESA account earning the cash rate less 25 basis points and another $20 in higher yielding private sector assets. The slope of the yield curve (long term v short term rates) and size of credit spreads (for private sector securities over government rates) are relevant factors in this calculation.

While these arrangements remain to be determined, if there is a build up of bank ESA balances (rather than holding other assets), the RBA’s cash rate target would see it acquiring additional assets from the banks (such as government securities) and potentially aggravating the shortage of HQLA.

The implication is that the whole structure of arrangements for system liquidity management may need to be reexamined.

[1] Basel Committee on Banking Supervision Basel III: International framework for liquidity risk measurement, standards and monitoring,  December 2010, http://www.bis.org/publ/bcbs188.pdf

[2] Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision, September 2008, http://www.bis.org/publ/bcbs144.htm

[3] After an observation period commencing in 2011, the LCR would apply from 1 January 2015 and the NSF from 1 January 2018.

[4]APRA “APRA clarifies implementation of global liquidity standards in Australia” Media Release 11-03, 28 February 2011.  http://www.apra.gov.au/media-releases/11_03.cfm

[5] Even if the crisis is a “flight to quality” with non-banks increasing their demand for government debt in exchange for bank deposits, the consequent liquidity adjustments of banks may create a need for RBA injection of liquidity.

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies and Professor of Finance, University of Melbourne.
info@australiancentre.com.au

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The Financial Regulation Discussion Paper Series provides independent analysis and commentary on current issues in Financial Regulation with the objective of promoting constructive dialogue among academics, industry practitioners, policymakers and regulators and contributing to excellence in Australian financial system regulation. More in this series

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