Consultation on the prudential framework for deposit takers and depositor protection
Submissions close on 23 October in the next round of consultation by Treasury and the Reserve Bank on the prudential framework for deposit takers and depositor protection. In this briefing, we focus on chapter 8 of the consultation document – depositor protection. In particular, we discuss depositor preference and whether the 2019 Capital Review may influence the decisions that are made.
Please contact one of our experts if you wish to discuss any aspects of the proposals in the consultation document. See a link to the paper here and our previous articles in this series here.
Background
Cabinet has agreed in-principle to the introduction of a depositor protection scheme. Under the scheme, deposits in New Zealand would be protected up to a total of $50,000 per depositor, per deposit taker. The protection of deposits would be effected through a compulsory insurance scheme. Deposit takers would be required to pay premium levies to the scheme insurer to fund the protection of deposits. It is possible that some of these costs at least would be passed on to the deposit takers' customers.
The consultation paper is now seeking feedback on the following issues:
- whether the depositor protection scheme should be complemented by a "depositor preference";
- the scope of products that should be covered by the scheme;
- the mandate and functions of the deposit insurer;
- governance of the deposit insurer; and
- funding arrangements for the scheme.
Depositor preference
At present, if a bank fails, depositors rank equally with other unsecured creditors in a liquidation of the bank. This would change if depositor preference is introduced, with deposit holders ranking above unsecured creditors in the liquidation of the deposit taker. If depositor preference is introduced in New Zealand, it is proposed that it would apply only to insured deposits – so the preference would apply only to the extent that depositor insurance applied.
One of the main benefits of depositor preference is that it would increase the recoveries available to the deposit insurer from a failed deposit taker. This would occur by the deposit insurer standing in the shoes of insured depositors and being entitled to receive the preferred distribution that otherwise would have been paid to those depositors. This preference should mean that the deposit insurer is able to recover the costs of a pay-out to deposit holders without having to impose exceptional levies on scheme members (ie remaining deposit takers).
While that may seem like good news for deposit takers, it may not necessarily be. A consequence of depositor preference is that unsecured creditors who do not provide funding in the form of insured deposits (eg bond holders) are disadvantaged, by ranking in a liquidation not only after creditors who effectively are secured (such as covered bond holders (and soon to be joined by RMO holders)) but also after preferred creditors (ie insured depositors). This could lead to an increase in the costs to the deposit taker of obtaining this important type of funding. Again, these increased costs may make their way, in part at least, to customers.
The Capital Review
Interestingly, the consultation document does not discuss in detail the final decisions made by the Reserve Bank in its 2019 Capital Review. Those decisions include significantly increasing the amount of capital banks must hold – to 18% in total of risk-weighted assets for domestic-systemically important banks and to 16% in total of risk weighted-assets for other banks. The bulk of this capital must be in the form of tier 1 capital.
In asking itself "Are these the Right Decisions?" on page 4 of the Capital Review, the Reserve Bank stated that the primary benefit of the Capital Review changes are an increase in financial stability and a reduction in the risk of banking crises. In figure 2 of the Capital Review, the probability of a crisis at current levels was said to be 1.82%, and this would fall to 0.5% with the 2019 reforms.
The risk of a bank failure would appear therefore to be low. Although the Capital Review is concerned with banks only, and not deposit takers more generally, we would have thought the risk of a crisis occurring could be relevant to the discussion on depositor preference. If the risk of a crisis is going to fall to 0.5%, then are the various layers of depositor protection in the broader sense (ie increased capital, statutory bail-in, deposit insurance, depositor preference), and the costs that are associated with each of those measures, all necessary? For instance, if depositor preference would lead to increased funding costs for deposit takers, can those costs be justified now if depositor preference is not likely to be used in practice? Or would it be better to avoid those costs now and take the risk that exceptional levies may need to be imposed in the unlikely event that a crisis arises?
What this shows is the importance of careful and co-ordinated decision-making and designing a framework that responds to New Zealand's particular circumstances.