The OECD Is Wrong About Deposit Insurance

The OECD has been hard at work preparing a fancy report that tries to impose globalist policies on New Zealand. One of their suggestions is that New Zealand should move to implement bank deposit insurance over the Open Bank Resolution model which would impose haircuts on bank depositors and wipe out shareholders in order to eliminate or significantly lower the cost of a big bank bailout.

The problem with globalist agencies trying to tell a sovereign country what policy options it should pursue is that it does so without any consideration of that country’s unique experience with that policy in the past is.

Remember the Crown Deposit Guarantee Scheme? That enabled our banks and finance companies to survive the worst of the “global financial crisis”. It also cost taxpayers billions of dollars – and led to our largest ever fraud trial coming to you soon in the form of South Canterbury Finance.

Deposit insurance, in the aftermath of Cyprus, which showed that all bank deposits are fair game in a bail-in, is nonsensical. The immediate reaction of South Canterbury Finance after getting into the Crown Deposit Guarantee was to ramp up its risky lending. Why? Because the cost of failure had been shifted from bondholders and shareholders to taxpayers.

In the case of the big banks, an argument can be made that, along with lower levels of syndication (shorter distance between borrower and owner of that mortgage) and absence of deposit insurance, our banking sector is slightly more risk averse than other banks around the world. When you add in recourse lending (you can’t walk away from an underwater mortgage without risking bankruptcy), New Zealand’s financial stability plan is working just fine thank you very much.

Already, the market is confused because there is no telling how the NZ government would react to a major bank getting into trouble. While Open Bank Resolution is quite explicit as to what the process is, political reality and convenience dictate that it would provide an optimal chance for a government to grandstand and “save the day”.

Bank depositors still do not understand that they are in a debtor/creditor relationship with their bank. Standard risk management principles apply even to regulated and well capitalised banks in this country. The OECD is wrong about deposit insurance because the marginal banks would be able to expand their loan books at a higher rate than their fundamentals would justify.

As economic thinkers, we want the taxpayer to be liable for the least amount of risk prudent in a risky global environment. The commentary written by globalist organisations like the OECD, IMF and World Bank aren’t that helpful in working towards sensible policy in New Zealand.

We have our own bundle of preferences that the median voter wants that are bad enough, adding dumb ideas that increase moral hazard risks and asymmetric information between regulators and the regulated does not help sensible bank regulation at all.

 

Do We Need Big Banks?

Humans can’t handle more than 150 relationships. It’s a throwback to our caveman past – when tribes exceeded 150 people, bonds of trust started to weaken and no one really knew what was up.

Big banks in New Zealand have thousands of employees and hundreds of thousands of customers. Big banks in the US have tens of thousands of employees and millions of customers. No one really knows what is going on because there are so many people involved in the banking sector.

Back in the olden days, before I was born, you used to have a relationship with a bank manager. When you went to apply for a loan, he knew your banking history, probably your parents and your grandparents too. If you were applying for a farm loan he’d have a decent knowledge of your farming ability.

This meant that the distance between savers and borrowers was small. Relationship banking meant knowing your customers, knowing the local community and knowing that if someone had good character they were likely to pay the bank back eventually.

Back in the olden days, there was also a lower incidence of bad behaviour. Defrauding banks still happened, but it was a lot harder than it is today. Because communities were smaller, the social shame effect could be used to lower the likelihood of default.

This is all in stark contrast to how the banking sector functions today. Credit approval is granted based on points and complicated models that evaluate a potential borrowers prospects.

Putting aside the role that fancy models played in the collapse of Long Term Capital Management, the NASDAQ technology collapse, the housing boom and rise of sub-prime, the derivatives on sovereign debt and even domestic housing developments, the big banks today have enormous distance between the savers and the borrowers.

In any system, when you centralise decision making, you lose knowledge at the coal face that matters. In his essay The Use of Knowledge In Society, F A Hayek argued that the reason central planning failed was because a committee couldn’t make price decisions for every single actor in an economy.

Central planning in the banking system is represented by centralised credit approval systems. They use fancy models that use crap models like “Value at Risk” because the regulators, who know very little about the real world, have mandated that those models are the true representation of the risk a bank is exposed to.

Dispersed knowledge applies just as much as the private sector as it does in the public sector. Dozens of local bank managers making subjective decisions is likely to be more stable than a centralised credit approval system.

The conceit, of course, is that a model is a simplification of reality. It is made up of assumptions, can disregard potentially relevant factors as “not useful” and applied to situations it really shouldn’t be.

Big banks in New Zealand today are walking blind through a minefield. Their loan default models are based on past default rates. Their “worst case scenario” stress testing models forget that the “worst case scenario” is always worse than the last worst case scenario before that!

We don’t really need big banks because the arguments they use to justify their existence, like they provide payment networks and the like, are redundant in the 21st century. They are a utility, the flash offices I see in Wellington belonging to big banks offends me deeply.

They should be as boring as water companies. Not some sexy, profitable, lavish executive pay with no clawbacks for imposing systemic risks on everyone else nirvana. The big banks have to go if we want any return to a realistic distance between savers and borrowers.

Bank Stress Testing And Open Bank Resolution

Bank stress testing is an interesting thing to think about. The goal is to model what would happen to bank income statements and balance sheets in the wake of “shocks” like house prices returning to realistic levels or people realising that paying debt back just gives executives bonuses and less disposable income for cool stuff.

The Reserve Bank’s latest Financial Stability Report includes some discussion of recent bank stress tests done in collaboration with the Reserve Bank of Australia.

The impaired asset expense estimations even when the “shocks” happen are extremely low. An impaired asset expense is recognising on an income statement that you’re unlikely to have a loan repaid.

This flows through to whether the bank makes a profit or loss. If they make a loss, they have to raise additional capital in order to retain high Tier 1 capital ratios under Basel III requirements.

There is $35 billion in wholesale funding that banks have to rollover to replace over the next 3 years. With the euro-zone crisis still nowhere near being resolved, and the LIBOR scandal, will there even be a functioning wholesale money market in 3 years?

To say that there will be is arrogant in the extreme. Just look at how quickly the overnight lending markets evaporated after Lehman Brothers. We have no idea what could trigger another freeze. What if Greece exits suddenly and the charade that the euro-zone still has some semblance of solvency evaporates?

The RBNZ and RBA worked with the banks’ own models in order to conduct stress tests. They do not say whether they adjusted the banks’ figures to reflect the incentive they have to under-report substantial losses they would incur if certain shocks happened.

There is also not much discussion on whether impaired asset expenses peaking at 2% is realistic at all. This is odd. Why? Because if a major shock happens and New Zealand goes into a deep recession, we have no way of telling how the dominos will fall.

What I mean by this is that we can’t say what will cause different businesses to make shutdown decisions in the wake of a deep recession. Some business owners might fear the worst, layoff their employees promptly and suddenly an extra 30-40 mortgages start falling behind.

What happens if impaired asset expense ratios go above 2%? And if banks aren’t able to raise capital either domestically or on the wholesale money markets?

They become insolvent. Their capital ratios fall below their Basel III requirements. There is a risk that no capital injection can be arranged and so we turn to the proposed Open Bank Resolution strategy.

While I won’t go into detail about how the Open Bank Resolution process will work, I will make one comment : what if the initial losses are far greater than what the Reserve Bank has considered in building their model?

Banks actually have a major incentive, if the government is going to guarantee solvency support of the unfrozen portion of their assets, to make hay while the sun shines.

Paying bank executives 7-figures salaries in gratitude for shifting potential taxpayer liabilities into the tens of billions of dollars, when there is no recourse for clawing back excessive compensation and excess returns that have been clawed off the table, is folly in the extreme.

We cannot tell what the actual level of losses will be. We cannot tell what the actual impaired asset expense will be if a major bank collapses a year or so after a deep recession.

This means that the most honest value of government solvency support to a bank admitted to the Open Bank Resolution scheme is $X billion to $XX billion.

Furthermore, if the RBNZ takes over an insolvent bank, are there measures in place to insure futures contracts are rolled over to avoid cash settlement? What if a $10 billion notional US Treasury position isn’t rolled over? Do term depositors or taxpayers stump up for that?

If I was employed by the RBNZ I would be actively “war gaming” things outside the model. What if the Australian government, for political reasons, doesn’t want its super funds to eat the losses of an insolvent big bank? What if the Australian High Commissioner takes a trip to the Beehive and tells Bill English that the New Zealand government will eat the losses in partnership with the Australian government?

Bank stress testing based on the numbers is better than no bank stress testing at all. But there needs to be some clear thinking about what “outside the model” potential hurdles might need to be overcome.

Due Diligence Questions For Investors

If you are thinking about investing in something, you have to do your due diligence. The finance company collapses, ponzi scheme failures and property investment scams that have been revealed following the global financial crisis ram home the fact that most investors don’t do their due diligence.

How can an average investor perform due diligence on a prospective investment? The truth is they probably can’t. If you don’t have above average knowledge of the relationship between risk and return, how probability actually works, what the law is surrounding investments and standard procedure for legitimate investment firms you should stick to investing in index funds.

The inability of the average investor to perform due diligence is why we have to make silly statements like “taking my investment advice without consulting a financial advisor or 3rd party solicitor first is really stupid”. The development of “plain English” product disclosure statements prepared in the format preferred by the Financial Markets Authority can’t account for how stupid some people are.

If you can’t explain to a reasonably clever teenager concepts like diversification, correlation of returns, the risks and rewards of Kiwisaver accounts, performance relative to benchmarks, impact of performance and management fees on long-term returns and answer questions that dullards send into Mary Holm every week you have no business going anywhere near the financial markets.

Armed with your above average knowledge of basic financial topics, you should be able to pigeon hole investment products you’re looking at. When you know the category of investment you are dealing with you can then ask the best questions for that category of investment. The Financial Markets Authority actually has some great information on its website. As does the Retirement Commission’s “Sorted”.

For example the Moa Brewery IPO can be filed under “new listing backed by guys with a track record of selling NZ brands for a premium to large corporates and non-trivial likelihood of success”. Examples of questions you’d want to answer before investing here would be:

  • How are the founders and IPO participants incentives aligned?
  • Who is managing the listing and what fees are they getting? Do they have to support the initial listing price?
  • What do the back-of-the-envelope calculations look like for the premium beer market?
  • What is the worst-case scenario if I put my money in the IPO?
  • What are the risks I am exposed to here? Currency risk? Distributor solvency risk? Consumer tastes and preferences risk?
  • Can I build a basic model in Excel that resembles what the Moa guys have put in the prospectus and test their assumptions?

If you are performing due diligence on a specific asset manager, there are lots of things you can do to lower the risk of getting “Madoffed”. Reading the disclosure documents very carefully is the first step. Then, conducting a detailed Google search on the asset manager, entities they are associated with, similar investment products, credit checks, background checks if you are investing a lot of money with one manager and testing whoever is trying to sell you the investment product with aggressive lines of questioning are all part of investigating whether an asset manager’s track record is plausible or someone is taking the mickey.

A clear understanding of probability and investment returns is also essential. Past performance does not predict future performance. Just because a hot-shot asset manager has beaten the NZX50 for the past decade doesn’t mean they possess some amazing ability. Never discount the possibility that someone has had really good luck and is rationalising their success by pointing to their “track record” and “investing acumen”.

If you’ve been reading this article and don’t understand every single concept I’m referring to, you have no business actively investing. The Financial Markets Authority should restrict investment products to people who are capable of performing due diligence independently.

Why is this? Well, it’s because in New Zealand we privatise profits and socialise the losses. If someone makes a bad investment and loses their retirement savings they will become a burden on every other Kiwi by accessing superannuation when they previously would have been able to decline it. They’ll also become eligible for nursing home subsidies if they haven’t stashed the rest of their assets in trusts.

Behavioural finance studies have proven that very few people are capable of making rational investment decisions. They are subject to enormous biases, under-estimate the likelihood that they are making a poor decision and over-estimate the likely returns from investment products they are considering. We think we know more about investing than we actually do and cry to the media when we make really dumb decisions.

I am not currently in a position to make substantial investments in hedge funds or pick individual stocks. My strategy at present is pure capital preservation and hedging against inflation. An index tracking product like the NZX SmartShares is the most reasonable level of risk I’d be comfortable with at this stage. Taking long-term bets with out-of-the-money options is too risky at present.

Handing over your entire investment strategy to a person whose incentives are not aligned with yours (think : commissions, kickbacks, golfing trips, liquid lunches at restaurants you’ve never heard of) and then losing it all is proof positive that financial darwinism exists.

If you are not prepared to do enormous groundwork in analysing potential investment products, doing the due diligence, clarifying things you don’t understand with your solicitor, asking your accountant whether claimed tax benefits are likely to result in an IRD audit or even performing a Google search on the potential investment provider and associated entities, you shouldn’t even consider index funds.

You could choose the conservative option on your Kiwisaver and keep all of your money in term deposits. But even then you’re an unsecured creditor to the Big Four banks and will get clipped if Open Bank Resolution is ever implemented. Do you even know how Open Bank Resolution will work? If not, you should take five minutes from your busy day to read about it.

I think you should read dozens of books before you go anywhere near the shark-infested waters of investing. If you don’t have a broad understanding of investing, risk and probability you are a mark for shysters who will take advantage of your naivety. Just because you have achieved success in one area of your life, namely having enough money to invest, doesn’t mean that success will transfer to your investing efforts.

I am reasonably smart. I read extremely widely in economics and finance. I have extremely low levels of confidence in the financial markets and the “professionals” who work there. Commingling of client funds and business funds, expenses being charged to investors and exceptionally poor after tax and after inflation returns make me wonder what excess return can be earned from assets even marginally more sophisticated than index funds like ETFs.

NB: For the illiterate I’m not an Authorised Financial Advisor and this shouldn’t be taken as financial advice tailored to your specific situation. If you actually don’t do your own research you are a dunce who deserves to lose everything. Search for an independent financial advisor who won’t charge commissions on investment products or read a few basic investing books before even visiting a sharebroker’s website or requesting information on something you’re unlikely to understand.