Sold A Pup – The Bank Deposit Bail-In

Let’s talk about the bank bail-in conundrum.  A couple of weeks back I discussed whether bank deposits in Australia would be safe in a crisis. The video received more than 1,400 views so far, and has prompted a number of important questions from viewers. So today I update the story, and addresses some of the questions raised.  The bottom line though is I think we are being sold a pup, which by the way refers to a confidence trick originating in the Late Middle Ages!

Watch the video, or read the transcript.

First, a quick recap, for those who missed the first video. Officially, in Australia currently bank deposits are protected up to $250,000 per person by a Government Guarantee – The Financial Claims Scheme.  For banks, building societies and credit unions incorporated in Australia, the FCS provides protection to depositors up to $250,000 per account-holder per ADI according to APRA. Only deposit products provided by ADIs supervised by APRA were eligible to be covered. Amounts between $250,000 and $1 million are not be covered under the Guarantee Scheme. Above $1m banks can elect to pay a fee to the Government for this for protection, but none do. However, as we will see there are even questions about the sub $250k.  But note this, the FCS can only be activated by the Australian Government, whilst APRA is responsible for administering the Scheme.

The RBA says upon its activation, APRA aims to make payments to account-holders up to the level of the cap as quickly as possible – generally within seven days of the date on which the FCS is activated. The method of payout to depositors will depend on the circumstances of the failed ADI and APRA’s assessment of the cost-effectiveness of each option. Payment options include cheques drawn on the RBA, electronic transfer to a nominated account at another ADI, transfer of funds into a new account created by APRA at another ADI, and various modes of cash payments.

The amount paid out under the FCS, and expenses incurred by APRA in connection with the FCS, would then be recovered via a priority claim of the Government against the assets of the ADI in the liquidation process.  If the amount realised is   insufficient, the   Government   can   recover   the shortfall through a levy on the ADI industry. Ok, maybe in the case of a single failure

Now, since the Global Financial Crisis, regulators have been working on ways to avoid a tax payer based rescue in a crash, because for example, the UK’s Royal Bank of Scotland was nationalised in 2007. This cost tax payers dear, so regulators want measures put in place to try to manage a more orderly transition when a bank gets into difficulty.

The New Zealand the Open Bank Resolution (not to be confused with Open Banking) is the clearest example of a so called bail-in arrangement. Customer’s money, held as savings in a distressed bank can be grabbed to assist in a resolution in a time of crisis. The thinking behind it is simple. Banks need an exit strategy in case of a problem, and Government bail-outs should not be an option. So a manager can be appointed to manage through the crisis. They can use bank capital, other instruments, like hybrid bonds and deposits to create a bail-in. This approach to rescuing a financial institution on the brink of failure makes its creditors and depositors take a loss on their holdings. This is the opposite of a bail-out, which involves the rescue of a financial institution by external parties, typically governments using taxpayer’s money.

So what about Australia? Well, the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017 is now law, having been through a Senate Inquiry. It all centers on the powers which were to be given to APRA to deal with a banking collapse.

In the bill, there is a phrase “any other instrument” in the list of bail-in items. Treasury said, “the use of the word ‘instrument’ is intended to be wide enough to capture any type of security or debt instrument that could be included within the capital framework in the future. It is not the intention that a bank deposit would be an ‘instrument’ for these purposes”. Yet, deposits were not expressly excluded.

In fact, when the Bill came back to Parliament it went through both houses with minimal discussion (and members on the floor, the chambers were all but empty). And despite a proposal being drafted and with Government Lawyers in parallel to exclude deposits, it was passed on 14^th February without this change, leaving the door wide open under “any other instrument”. All the verbal assurances are meaningless.

So, the result appears to be APRA has wider powers now to handle a bank in crisis, and deposits are potentially accessible.  They are not expressly excluded, and in a time of crisis, could be bailed-in.

But this is not the end of the story. Treasurer Morrison issued a letter to Liberal government members with some talking points to justify this actions, in response to a wave of protests. But in so doing, he raises more questions.

The first point is that the Deposit Guarantee scheme (the one up to $250k) is not currently active. The Government would need to activate it, and can only do so when an institution fails.  This is important because it means that in theory at least, APRA could mount a deposit bail-in before the Government activates the deposit protection scheme. Consider what would happen if many banks all got into difficulty at the same time, as could be the case in a wider banking crisis – after all, they all have similar banking models.

The second point is that the Treasurer makes reference to the 1959 Banking Act, and says that depositors have a claim above other creditors in a bank failure. But in fact the 1959 Act says depositors do indeed rank ahead of other unsecured creditors, but that means the secured creditors come first. So would anything be left in case of a bank failure given the massive exposure to property?

Next, the letter says APRA has now enhanced powers to protect the interests of depositors – not deposits. And looking at the New Zealand situation the bail-in provisions there are framed to do just this, by utilising deposits to help keep the bank afloat, thus protecting depositors. The Reserve Bank of New Zealand says this is IN THE INTERESTS OF DEPOSITORS.

Oh, and finally, Morrison says the way the Bill went into Law was quite normal by being listed in the Senate Order of Business, meaning members had the opportunity to debate the bill if they had wanted to.  In fact, only seven Senators were there despite really needing a quorum of 19, but there is a get out in that a quorum is only needed if a division was called, and in this case it was simply nodded through. Democracy in action.

So there you have it. No Deposit Protection currently exists. Its limited to $250k per person if activated by the Government, at their discretion, and the legalisation leaves the door wide open for a New Zealand style of Bail-In. Not a good look.

So what should Savers do? Well, this is not financial advice, but the New Zealand view is that savers should make a risk assessment of banks and select where to deposit funds accordingly. But I am not sure how you do that, given the current low level of disclosures. APRA releases mainly aggregate data and protects the confidentially of individual banks as they are required to do under the APRA act.

Next, do not assume deposits are risk free, they are not. This means lenders should be offering rates of return more reflective of the risks we are taking, currently they are not (in fact deposit rates are sliding, as banks seek to repair margins).  You might consider spreading the risks across multiple institutions

Consider alternative savings options (which are limited). Clearly, property, stocks and shares and even crypto currencies are all risky – there are no safe harbours. I guess there is always the mattress.

One other point to make. Several people are calling a bill to bring a Glass-Steagall split between core banking operations and the speculative aspects of banking. Glass-Steagall was enacted in the US in 1933 after the great crash, separating commercial and investment banking and preventing securities firms and investment banks from taking deposits. But in 1999 the US Congress passed the Gramm–Leach–Bliley Act, also known as the Financial Services Modernization Act, to repeal them. Eight days later, President Bill Clinton signed it into law.  Following the financial crisis of 2007-2008, legislators unsuccessfully tried to reinstate Glass–Steagall Sections 20 and 32 as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act. Both in the United States and elsewhere, banking reforms have been proposed that refer to Glass–Steagall principles. These proposals include issues of “ring fencing” commercial banking operations and narrow banking proposals that would sharply reduce the permitted activities of commercial banks.

The point of the bill was to isolate the risky bank behaviour, relating to derivatives and trading from core banking activities.  In the case of a banking crisis, triggered by a collapse in the financial markets such an arrangement would protect the operations of the core banking. We got a glimpse of that a month ago when US trading volatility shot through the roof.

But, in Australia, the bulk of the risks in the banking system comes not from the derivatives side of the business, but the massive exposure to household debt and the property sector, and the risky loans they have made. We discussed this on the ABC yesterday. More than 60% of all banking assets are aligned with home lending, plus more relating to commercial property. Thus I do not believe a Glass-Stegall type separation would help to mitigate risks to the banking sector here much at all.

Better to push for a definitive change to the APRA Bill and get deposits excluded from the risk of bail-in.  Or place a levy on all banks to directly protect depositors as has been put in place in Germany, where a dedicated government entity has been created for just this purpose.

What I find remarkable is that following loose banking regulation for years, during which the banks have returned massive profits to shareholders, and ramped up their risks, depositors are being lined up by the Government to bail out a failing bank. This is simply wrong.