Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective

The ability to raise funding via “deposits” is one of the things that makes banks different from other types of companies. As a rule bank deposits benefit from a variety of protections that transform what is effectively an unsecured loan to a highly leveraged company into an (arguably) risk free asset.

This rule is not universal however. The NZ banking system, for example, has a distinctly different approach to bank deposits that not only eschew the protections Australian depositors take for granted but also has the power, via its Open Banking Resolution regime, to write down the value of bank deposits if required to ensure the solvency and viability of a bank. But some form of protection is common.

I previously had a go at the question of “why” bank deposits should be protected here.

This post focuses on the mechanics of “how” AUD denominated deposits held with APRA authorised deposit-taking institutions incorporated in Australia (“Australian ADIs” or “Australian banks”) are protected. In particular, I attempt to rank the relative importance of the various protections built into the Australian system. You may not necessarily agree with my ranking and that is OK – I would welcome feedback on what I may be missing.

Multiple layers of protection

Australian bank deposits benefit from multiple layers of protection:

  1. The risk taking activities of the banks are subject to a high level of supervision and regulation (that is true to varying degrees for most banking systems but Australian standards do seem to be at the more conservative end of the spectrum where Basel Committee standards offer a choice),
  2. The target level of Common Equity Tier 1 (CET1) capital required to support that risk must meet the standard of being “Unquestionably Strong”,
  3. This core capital requirement is supported by a series of supplementary layers of loss absorbing capital that can be converted into equity if the viability of the bank as a going concern comes into doubt,
  4. The deposits themselves have a priority super senior claim on the Australian assets of the bank should it fail, and
  5. The timely repayments of AUD deposits up to $250,000 per person per bank is guaranteed by the Australian Government.

Deposit preference rules …

The government guarantee might seem like the obvious candidate for the layer of protection that counts for the most, but I am not so sure. All the layers of protection obviously contribute but my vote goes to deposit preference. The capacity to bail-in the supplementary capital gets an honourable mention. These seem to me to be the two elements that ultimately underwrite the safety of the majority of bank deposits (by value) in Australia.

The other elements are also important but …

Intensive supervision clearly helps ensure that banks are well managed and not taking excessive risks but experience demonstrates that it does not guarantee that banks will not make mistakes. The Unquestionably Strong benchmark for CET1 capital developed in response to one of the recommendations of the 2014 Financial System Inquiry also helps but again does not guarantee that banks will not find some new (or not so new) way to blow themselves up.

At face value, the government guarantee seems like it would be all you need to know about the safety of bank deposits (provided you are not dealing with the high quality problem of having more than AUD250,000 in you bank account). When you look at the detail though, the role the government guarantee plays in underwriting the safety of bank deposits seems pretty limited, especially if you hold you deposit account with one of the larger ADIs. The first point to note is that the guarantee will only come into play if a series of conditions are met including that APRA consider that the ADI is insolvent and that the Treasurer determines that it is necessary.

In practice, recourse to the guarantee might be required for a small ADI heavily reliant on deposit funding but I suspect that this chain of events is extremely unlikely to play out for one of the bigger banks. That is partly because the risk of insolvency has been substantially reduced by higher CET1 requirements (for the larger ADI in particular) but also because the government now has a range of tools that allow it to bail-in rather than bail-out certain bank creditors that rank below depositors in the loss hierarchy. There are no great choices when dealing with troubled banks but my guess is that the authorities will choose bail-in over liquidation any time they are dealing with one of the larger ADIs.

If deposit preference rules, why doesn’t everyone do it?

Banking systems often seem to evolve in response to specific issues of the day rather than being the result of some grand design. So far as I can tell, it seems that the countries that have chosen not to pursue deposit preference have done so on the grounds that making deposits too safe dilutes market discipline and in the worst case invites moral hazard. That is very clearly the case in the choices that New Zealand has made (see above) and the resources they devote to the disclosure of information regarding the relative risk and strength of their banks.

I understand the theory being applied here and completely agree that market discipline should be encouraged while moral hazard is something to be avoided at all costs. That said, it does not seem reasonable to me to expect that the average bank deposit account holder is capable of making the risk assessments the theory requires, nor the capacity to bear the consequences of getting it wrong.

Bank deposits also function as one of the primary forms of money in most developed economies but need to be insulated from risk if they are to perform this role. Deposit preference not only helps to insulate this component of our money supply from risk, it also tends to transfer the risk to investors (debt and equity) who do have the skills and the capacity to assess and absorb it, thereby encouraging market discipline.

The point I am making here is very similar to the arguments that Grant Turner listed in favour of deposit protection in a paper published in the RBA Bulletin.

There are a number of reasons why authorities may seek to provide greater protection to depositors than to other creditors of banks. First, deposits are a critical part of the financial system because they facilitate economic transactions in a way that wholesale debt does not. Second, they are a primary form of saving for many individuals, losses on which may result in significant adversity for depositors who are unable to protect against this risk. These two characteristics also mean that deposits are typically the main source of funding for banks, especially for smaller institutions with limited access to wholesale funding markets. Third, non-deposit creditors are generally better placed than most depositors to assess and manage risk. Providing equivalent protection arrangements for non-deposit creditors would weaken market discipline and increase moral hazard.

Depositor Protection in Australia, Grant Turner, RBA Bulletin December Quarter 2011 (p45)

For a more technical discussion of these arguments I can recommend a paper by Gary Gorton and George Pennacchi titled “Financial Intermediation and Liquidity Creation” that I wrote about in this post.

Deposit preference potentially strengthens market discipline

I argued above that deposit preference potentially strengthens market discipline by transferring risk to debt and equity investors who have the skills to assess the risk, are paid a risk premium for doing so and, equally as importantly, the capacity to absorb the downside should a bank get into trouble. I recognise of course that this argument is strongest for the larger ADIs which have substantial layers of senior and subordinated debt that help ensure that deposits are materially insulated from bank risk. The capacity to bail-in a layer of this funding, independent of the conventional liquidation process, further adds to the protection of depositors while concentrating the role of market discipline where it belongs.

This market discipline role is one of the chief reasons I think “bail-in” adds to the resilience of the system in ways that higher equity requirements do not. The “skin in the game” these investors have is every bit as real as that the equity investors do, but they have less incentive to tolerate excessive or undisciplined risk taking.

The market discipline argument is less strong for the smaller ADIs which rely on deposits for a greater share of their funding but these entities account for a smaller share of bank deposits and can be liquidated if required with less disruption with the assistance of the government guarantee. The government guarantee seems to be more valuable for these ADIs than it is for the larger ADIs which are subject to a greater level of self-insurance.

Deposit preference plus ex ante funding of the deposit guarantee favours the smaller ADI

Interestingly, the ex ante nature of the funding of the government guarantee means that the ADIs for which it is least valuable (the survivors in general and the larger ADI’s in particular) are also the ones that will be called upon to pay the levy to make good any shortfalls not covered by deposit preference. That is at odds with the principle of risk based pricing that features in the literature about deposit guarantees but arguably a reasonable subsidy that assists the smaller ADIs to compete with larger ADI that have the benefit of risk diversification and economies of scale.

Summing up

If you want to dig deeper into this question, I have summarised the technical detail of the Australian deposit protection arrangements here. It is a little dated now but I can also recommend the article by Grant Turner published in the RBA Bulletin (December 2011) titled “Depositor Protection in Australia” which I quoted from above.

As always, it is entirely possible that I am missing something – if so let me know.

Tony – From The Outside

Digital money – FT Alphaville

FT Alphaville is one of my go to sources for information and insight. The Alphaville post flagged below discusses the discussion paper recently released by the Bank of England on the pros and cons of a Central Bank Digital Currency. It is obviously a technical issue but worth at least scanning if you have any interest in banking and ways in which the concept of “money” may be evolving.

Read on ftalphaville.ft.com/2020/03/12/1584053069000/Digital-stimulus/

Deposit insurance and moral hazard

Depositors tend to be a protected species

It is generally agreed that bank deposits have a privileged position in the financial system. There are exceptions to the rule such as NZ which, not only eschews deposit insurance, but also the practice of granting deposits a preferred (or super senior) claim on the assets of the bank. NZ also has a unique approach to bank resolution which clearly includes imposing losses on bank deposits as part of the recapitalisation process. Deposit insurance is under review in NZ but it is less clear if that review contemplates revisiting the question of deposit preference.

The more common practice is for deposits to rank at, or near, the top of the queue in their claim on the assets of the issuing bank. This preferred claim is often supported by some form of limited deposit insurance (increasingly so post the Global Financial Crisis of 2008). An assessment of the full benefit has to consider the cost of providing the payment infrastructure that bank depositors require but the issuing bank benefits from the capacity to raise funds at relatively low interest rates. The capacity to raise funding in the form of deposits also tends to mean that the issuing banks will be heavily regulated which adds another layer of cost.


The question is whether depositors should be protected

I am aware of two main arguments for protecting depositors:

  • One is to protect the savings of financially unsophisticated individuals and small businesses.
  • The other major benefit relates to the short-term, on-demand, nature of deposits that makes them convenient for settling transactions but can also lead to a ‘bank run’.

The fact is that retail depositors are simply not well equipped to evaluate the solvency and liquidity of a bank. Given that even the professionals can fail to detect problems in banks, it is not clear why people who will tend to lie at the unsophisticated end of the spectrum should be expected to do any better. However, the unsophisticated investor argument by itself is probably not sufficient. We allow these individuals to invest in the shares of banks and other risky investments so what is special about deposits.

The more fundamental issue is that, by virtue of the way in which they function as a form of money, bank deposits should not be analysed as “investments”. To function as money the par value of bank deposits must be unquestioned and effectively a matter of faith or trust. Deposit insurance and deposit preference are the tools we use to underwrite the safety and liquidity of bank deposits and this is essential if bank deposits are to function as money. We know the economy needs money to facilitate economic activity so if bank deposits don’t perform this function then you need something else that does. Whatever the alternative form of money decided on, you are still left with the core issue of how to make it safe and liquid.

Quote
“The capacity of a financial instrument like a bank deposit to be accepted and used as money depends on the ability of uninformed agents to trade it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty”

Gary Gorton and George Pennacchi “Financial Intermediaries and Liquidity Creation”

I recognise that fintech solutions are increasingly offering alternative payment mechanisms that offer some of the functions of money but to date these still ultimately rely on a bank with a settlement account at the central bank to function. This post on Alphaville is worth reading if you are interested in this area of financial innovation. The short version is that fintechs have not been able to create new money in the way banks do but this might be changing.

But what about moral hazard?

There is an argument that depositors should not be a protected class because insulation from risk creates moral hazard.

While government deposit insurance has proven very successful in protecting banks from runs, it does so at a cost because it leads to moral hazard (Santos, 2000, p. 8). By offering a guarantee that depositors are not subject to loss, the provider of deposit insurance bears the risk that they would otherwise have borne.

According to Dr Sam Wylie (2009, p. 7) from the Melbourne Business School:

“The Government eliminates the adverse selection problem of depositors by insuring them against default by the bank. In doing so the Government creates a moral hazard problem for itself. The deposit insurance gives banks an incentive to make higher risk loans that have commensurately higher interest payments. Why?, because they are then betting with taxpayer’s money. If the riskier loans are repaid the owners of the bank get the benefit. If not, and the bank’s assets cannot cover liabilities, then the Government must make up the shortfall”

Reconciling Prudential Regulation with Competition, Pegasus Economics, May 2019 (p17)

A financial system that creates moral hazard is clearly undesirable but, for the reasons set out above, it is less clear to me that bank depositors are the right set of stakeholders to take on the responsibility of imposing market discipline on banks. There is a very real problem here but requiring depositors to take on this task is not the answer.

The paper by Gorton and Pennacchi that I referred to above notes that there is a variety of ways to make bank deposits liquid (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the assets of the bank that any volatility in their value is of no concern. This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does. Combining deposit insurance with a preferred claim on a bank’s assets also means that the government can underwrite deposit insurance with very little risk of loss.

It is also important I think to recognise that deposit preference moves the risk to other parts of the balance sheet that are arguably better suited to the task of exercising market discipline. The quote above from Pegasus Economics focussed on deposit insurance and I think has a fair point if the effect is simply to move risk from depositors to the government. That is part of the reason why I think that deposit preference, combined with how the deposit insurance is funded, are also key elements of the answer.

Designing a banking system that addresses the role of bank deposits as the primary form of money without the moral hazard problem

I have argued that the discussion of moral hazard is much more productive when the risk of failure is directed at stakeholders who have the expertise to monitor bank balance sheets, the capacity to absorb the risk and who are compensated for undertaking this responsibility. If depositors are not well suited to the market discipline task then who should bear the responsibility?

  • Senior unsecured debt
  • Non preferred senior debt (Tier 3 capital?)
  • Subordinated debt (i.e. Tier 2 capital)
  • Additional Tier 1 (AT1)
  • Common Equity Tier 1 (CET1)

There is a tension between liquidity and risk. Any security that is risky may be liquid during normal market conditions but this “liquidity” cannot be relied on under adverse conditions. Senior debt can in principle be a risky asset but most big banks will also aim to be able to issue senior debt on the best terms they can achieve to maximise liquidity. In practice, this means that big banks will probably aim for a Long Term Senior Debt Rating that is safely above the “investment grade” threshold. Investment grade ratings offer not just the capacity top issue at relatively low credit spreads but also, and possibly more importantly, access to a deeper and more reliable pool of funding.

Cheaper funding is nice to have but reliable access to funding is a life and death issue for banks when they have to continually roll over maturing debt to keep the wheels of their business turning. This is also the space where banks can access the pools of really long term funding that are essential to meet the liquidity and long term funding requirements that have been introduced under Basel III.

The best source of market discipline probably lies in the space between senior debt and common equity

I imagine that not every one will agree with me on this but I do not see common equity as a great source of market discipline on banks. Common equity is clearly a risky asset but the fact that shareholders benefit from taking risk is also a reason why they are inclined to give greater weight to the upside than to the downside when considering risk reward choices. As a consequence, I am not a fan of the “big equity” approach to bank capital requirements.

In my view, the best place to look for market discipline and the control of moral hazard in banking lies in securities that fill the gap between senior unsecured debt and common equity; i.e. non-preferred senior debt, subordinated debt and Additional Tier 1. I also see value in having multiple layers of loss absorption as opposed to one big homogeneous layer of loss absorption. This is partly because it can be more cost effective to find different groups of investors with different risk appetites. Possibly more important is that multiple layers offer both the banks and supervisors more flexibility in the size and impact of the way these instruments are used to recapitalise the bank.

Summing up …

I have held off putting this post up because I wanted the time to think through the issues and ensure (to the best of my ability) that I was not missing something. There remains the very real possibility that I am still missing something. That said, I do believe that understanding the role that bank deposits play as the primary form of money is fundamental to any complete discussion of the questions of deposit insurance, deposit preference and moral hazard in banking.

Tony

Are banks a special kind of company (or at least different)?

This is a big topic, and somewhat irredeemably technical, but I have come to believe that there are some unique features of banks that make them quite different from other companies. Notwithstanding the technical challenges, I think it is important to understand these distinguishing features if we are to have a sensible debate about the optimum financing structure for a bank and the kinds of returns that shareholders should expect on the capital they contribute to that structure.

You could be forgiven for thinking that the Australian debate about optimum capital has been resolved by the “unquestionably strong” benchmark that APRA has set and which all of the major banks have committed to meet. However, agreeing what kind of return is acceptable on unquestionably strong capital remains contentious and we have only just begun to consider how the introduction of a Total Loss Absorbing Capital (TLAC) requirement will impact these considerations.

The three distinctive features of banks I want to explore are:

  • The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
  • The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
  • The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.

It should be noted at the outset that Anat Admati and Martin Hellwig (who are frequently cited as authorities on the issues of bank capital discussed in this post) disagree with most if not all of the arguments I intend to lay out. So, if they are right, then I am wrong. Consequently, I intend to first lay out my understanding of why they disagree and hopefully address the objections they raise. They have published a number of papers and a book on the topic but I will refer to one titled “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as the primary source of the counter arguments that I will be attempting to rebut. They are of course Professors whereas I bring a lowly masters degree and some practical experience to the debate. Each reader will need to decide for themselves which analysis and arguments they find more compelling.

Given the size of the topic and the technical nature of the issues, I also propose to approach this over a series of posts starting with the relationship between bank lending and deposit creation. Subsequent posts will build on this foundation and consider the other distinctive features I have identified before drawing all of the pieces together by exploring some practical implications.

Do banks create “money”? If so, how does that impact the economics of bank funding?

The Bank of England (BoE) released a good paper on the first part of this question titled “Money creation in the modern economy” .  The BoE paper does require some banking knowledge but I think demonstrates reasonably clearly that the majority of bank deposits are created by the act of a bank making a new loan, while the repayment of bank loans conversely reduces the pool of deposits. The related but more important question for the purposes of this discussion is whether you believe that bank deposits are a form of money.

Admati and Hellwig identify the argument that “banks are special because they create money” as Flawed Claim #5 on the grounds that treating deposits as money is an abuse of the word “money”. They are not disputing the fact that monetary economists combine cash with demand deposits in one of the definitions of money. As I understand it, the essence of their argument is that deposits are still a debt of the issuing bank while “real” money does not need to be repaid to anyone.

It is true that deposits are a bank debt and that some deposits are repayable on demand. However, I believe the bigger issues bearing on the economics of bank financing stem from the arguments Admati and Hellwig advance to debunk what they label as Flawed Claim #4 that “The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies“.

Their argument appears to focus on using Modigliani and Miller (“M&M”) as an “analytical approach” in which the cost (contractual or expected) of the various forms of financing are connected by a universal law of risk and reward. Their argument is that this universal law (analogous to the fundamental laws of physics) demands that using more or less equity (relative to debt) must translate to a lower or higher risk of insolvency and that rational debt investors will respond by adjusting the risk premium they demand.

I have no issue with the analytical approach or the premise that funding costs should be related to risk. What happens however when one of the primary forms of debt funding is largely protected from the risk of insolvency? In the case of the major Australian banks, deposits account for over half of a bank’s total funding but are largely isolated from the risk of insolvency by a number of features. One is the Banking Act that confers a preferred claim in favour of Australian depositors over the Australian assets of the bank. The other is government guaranteed deposit insurance coverage capped at $250,000 per person per bank. The rationale for these acts of apparent government generosity is a contentious subject in itself but, for the purposes of this post, my working hypothesis is that the preferred claim and deposit insurance are a consequence of the fact that the community treats bank demand deposits as a form of money.

Consequently, the risk that an Australian depositor will face a loss of principal in the already remote event of insolvency is arguably de minimis and the way that demand deposits are priced and the way they are used as a substitute for cash reflects this risk analysis. There remains a related, though separate, risk that a bank may face a liquidity problem but depositors (to the extent they even think about this) will assume that central bank Lender of Last Resort liquidity support covers this.

Admati and Hellwig do not, to the best of my knowledge, consider the implications of these features of bank funding. In their defence, I don’t imagine that the Australian banking system was front of mind when they wrote their papers but depositor preference and deposit insurance are not unique Australian innovations. However, once you consider these factors, the conclusion I draw is that the cost of a substantial share of a bank’s debt financing is relatively (if not completely) insensitive to changes in the amount of equity the bank employs in its financing structure.

One consequence is that the higher levels of common equity that Australian banks employ now, compared to the position prior to the GFC, has not resulted in any decline in the cost of deposit funding in the way that M&M say that it should. In fact, the more conservative funding and liquidity requirements introduced under Basel III have required all banks to compete more aggressively for the forms of deposit funding that are deemed by the prudential requirements to be most stable thereby driving up the cost.

The point here is not whether these changes were desirable or not (for the record I have no fundamental issue with the Unquestionably Strong capital benchmark nor with more conservative funding and liquidity requirements). The point is that the cost of deposit funding, in Australian banking at least, has not declined in the way that Admati and Hellwig’s analytical approach and universal law demands that it should.

Summing up, it is possible that other forms of funding have declined in cost as Admati and Hellwig claim should happen, but there is both an analytical rationale and hard evidence that this does not appear to be the case, for Australian bank deposits at least.

The next post will consider the other main (non equity) components of a bank funding structure and explore how their risk/cost has evolved in response both to the lessons that investors and rating agencies took away from the GFC and to the changes in bank regulation introduced by Basel III. A subsequent post will review issues associated with measuring the Expected Loss and hence the true “Through the Cycle” profitability of a bank before I attempt to bring all of the pieces together.

There is a lot of ground to cover yet. At this stage, I have simply attempted to lay out a case for why the cost of bank deposits in Australia has not obeyed the universal analytical law posited by Admati and Hellwig as the logical consequence of a bank holding more equity in its financing structure but if you disagree tell me what I am missing …

Tony

Post script: The arguments I have laid out above could be paraphrased as “banks deposits differ from other kinds of debt because banks themselves create deposits by lending” which Admati and Hellwig specifically enumerate as Flawed Claim #6. I don’t think their rebuttal of this argument adds much to what is discussed above but for the sake of completeness I have copied below the relevant extract from their paper where they set out why they believe this specific claim is flawed. Read on if you want more detail or have a particular interest in this topic but I think the main elements of the debate are already covered above. If you think there is something here that is not covered above then let me know.

Flawed Claim 6: Bank deposits differ from other kinds of debt because banks create deposits by lending.

What is wrong with this claim? This claim is often made in opposition to a “loanable funds” view of banks as intermediaries that collect deposits in order to fund their loans. Moreover, this “money creation through lending” is said to be the way money from the central bank gets into the economy.19 The claim rests on a confusion between stocks and flows. Indeed, if a commercial bank makes a loan to a nonfinancial firm or to a private household it provides its borrowers with a claim on a deposit account. Whereas this fact provides a link between the flow of new lending and the flow of new deposits, it is hardly relevant for the bank’s funding policy, which concerns the stocks of different kinds of debt and equity that it has outstanding, which must cover the stocks of claims on borrowers and other assets that the bank holds.

A nonfinancial firm or household that receives a loan from a bank will typically use the associated claim on a deposit account for payments to third parties. The recipients of these payments may want to put some of the money they get into deposits, but they may instead prefer to move the money out of the banking system altogether, e.g., to a money market fund or a stock investment fund. 20

From the perspective of the individual bank, the fact that lending goes along with deposit creation does not change the fact that the bank owes its depositors the full amount they deposited. The key difference between deposits and other kinds of debt is not that deposits are “like money” or that deposits may be created by lending, but rather that the bank provides depositors with services such as payments through checks and credit cards or ATM machines that make funds available continuously. The demand for deposits depends on these services, as well as the interest that the bank may offer, and it may also depend on the risk of the bank becoming insolvent or defaulting.21

The suggestion that bank lending is the only source of deposit creation is plainly false.22 Deposits are created when people bring cash to the bank, and they are destroyed when people withdraw cash. In this case, the reduction in deposits – like any reduction in funding – goes along with a reduction in the bank’s assets, i.e., a shortening of its balance sheet, but this reduction affects the bank’s cash reserves rather than its lending. The impact of such withdrawals on banks and entire banking systems are well known from the Great Depression or from the recent experience of Greece. In Greece in the spring and summer of 2015, depositors also were worried about the prospect that in the event of the country’s exit from the euro, their denomination of their deposits would be changed, whereas a stack of bills under a matrass would not be affected.