Tag: Deposit Preference

Deposit insurance under review

Admittedly I only managed a skim read of the FDIC report dated 1 May 2023 on “Options for Deposit Insurance Reform” but I was a bit underwhelmed given the important role deposit insurance plays in the banking system. I think the conclusion that some form of increased but “targeted” coverage makes sense but I was disappointed by the discussion of the consequences for market discipline and moral hazard that might flow from such a move.

The Report considers three options for increasing deposit insurance:

  • Limited Coverage under which the current system would be maintained but the deposit insurance limit might increased above the existing USD250,000 threshold
  • Unlimited Coverage under which all deposits would be fully insured; and
  • Targeted Coverage under which coverage for “business payment accounts” would be substantially increased without significantly changing the limit for other deposits.

The report:

  • Concludes that “Targeted Coverage … is the most promising option to improve financial stability relative to its effect on bank risk-taking, bank funding, and broader markets”
  • But notes there are significant unresolved practical challenges “…including defining accounts for additional coverage and preventing depositors and banks from circumventing differences in coverage”

What I thought was interesting was that the Report seemed to struggle to make up its mind on the role of bank depositors in market discipline. On the one hand the Report states

“Monitoring bank solvency involves fixed costs, making it both impractical and inefficient for small depositors to conduct due diligence. Monitoring banks is also time consuming and requires financial, regulatory, and legal expertise that cannot be expected of small depositors”

Executive Summary, Page 1

… and yet there are repeated references to the ways in which increasing coverage will reduce depositor discipline. The discussion of the pros and cons of Targeted Coverage, for example, states

“The primary drawbacks to providing greater or unlimited coverage to specific account types are the potential loss in depositor discipline and resulting implications for bank-risk taking”

Section6: Options for Increased Deposit Coverage”, Page 58

I am not in favour of unlimited deposit insurance coverage but if you accept that certain types of depositors can’t be expected to monitor bank solvency (and liquidity) then I can’t see the point of saying that reduced depositor discipline is a consequence of changing deposit insurance for these groups or that the “burden” of monitoring is shifted to other stakeholders.

What would have been useful I think is a discussion of which stakeholders are best suited to monitor their bank and apply market discipline. Here again I found the Report disappointing. The Report states “… other creditors and shareholders may continue to play an important role in constraining bank risk-taking …” but does not explore the issue in any real detail.

I also found it confusing that ideas like placing limits on the reliance on uninsured deposits or requirements to increase the level of junior forms of funding (equity and subordinated debt), that were listed as “Potential Complementary Tools” for Limited Coverage and Unlimited Coverage, were not considered relevant in the Targeted Coverage option (See Table 1.1, page 5).

This ties into a broader point about the role of deposit preference. Most discussions about bank deposits focus on regulation, supervision and deposit insurance as the key elements that mitigate the inherent risk that deposits will run. Arguably, the only part of this that depositors understand and care about is the deposit insurance.

I would argue that deposit preference also has an important role to play for two reasons

  • Firstly, it mitigates the cost of deposit insurance by mitigating the risk that assets will be insufficient to cover insured deposits leaving the fund to make good the loss
  • Secondly, it concentrates the debate about market discipline on the junior stakeholders who I believe are best suited to the task of monitoring bank risk taking and exercising market discipline.

I did a post here which discussed the moral hazard question in more depth but the short version is that the best source of market discipline probably lies in the space between senior debt and common equity i.e. Additional Tier 1 and Tier 2 subordinated debt. Common equity clearly has some role to play but the “skin in the game” argument just does not cut it for me. The fact that shareholders benefit from risk taking tends to work against their incentive to provide risk discipline and more capital can have the perverse effect of creating pressure to look for higher returns.

Tony – From the Outside

The Secret Diary of a Bank Analyst …

… is the title of a post that Marc Rubinstein dropped this week summarising his perspective on why banks don’t behave like other companies. This is a question I have long been pursuing and I found Marc’s post well worth reading. Marc lists the following factors:

  1. Customer or Creditor
  2. Public or Private
  3. Growth is … not good
  4. Confidence is king
  5. Nobody knows anything

Let’s start with a quick outline of Marc’s observations about why banks don’t behave like other companies.

1) Customer or Creditor?

Marc writes …

“The first thing to understand about banks is that they operate a unique financial structure. Other companies borrow from one group of stakeholders and provide services to another. For banks, these stakeholders are one and the same: their creditors are their customers.”

This is oversimplifying a bit. Banks do also borrow from the bond markets but the key point is that deposits do typically from a large part of a bank’s liability stack and depositors clearly have a customer relationship. Understanding this is fundamental to understanding the business of banking.

2) Public or Private

Marc writes …

“Banks have a licence to create money which confers on them a special status somewhere between private enterprise and public entity. Economists argue that commercial banks create money by making new loans. When a bank makes a loan, it credits the borrower’s bank account with a deposit the size of the loan. At that moment, new money is created.”

He notes that the privilege of creating money comes at the price of being heavily regulated. Getting a banking licence is not easy and once granted banks must comply with a range of capital and liquidity requirements tied to the riskiness of their assets and liabilities. They are also subject to intense oversight of what they do and how they do it.

All of that is pretty well known but Marc makes another observation that may not be so widely understood but is possibly more important because of the uncertainty it injects into the business of banking

“All of this lies in the normal course of business for a bank. What is sometimes overlooked, because it is utilised so infrequently, is the executive power that authorities retain over banks. In some countries, where state owned banks dominate the market, intervention is explicit … But even when a bank is notionally private, the state can exercise direct influence over its operations.”

3) Growth is … not good

Marc writes …

“Most companies thrive on growth. “If you’re not growing, you’re dying,” they say. For investors, growth is a key input in the valuation process. 

But if your job is to create money, growth is not all that hard. And if the cost of generating growth is deferred, because the blowback from mispricing credit isn’t apparent until further down the line, it makes growth even easier to manufacture.”

This certainly resonates with my experience of banking. If you are growing faster than the system as a whole (or aspire to) then you should be asking yourself some hard questions about how you are going to achieve this. Are you really providing superior service or product or are you growing by giving up one or both of margin and credit quality. At the very least, it is important to recognise that growth is often achieved at the expense of Net Interest Margin (NIM) and everyone agrees that a declining NIM is a very big negative for bank valuations.

Marc goes on to observe that …

“The corollary to this is that., unlike in other industries, competition is not necessarily that good either – or at least it comes with a trade-off against financial stability”

Some economists might struggle with this but bank supervisors as a rule can be relied on to chose stability over competition. Marc notes however that US are a possible exception to the general rule …

US authorities are unusually squeamish about the trade-off. Partly, it reflects a respect for private markets but mostly it’s because their smaller banks harness significant lobbying power. …

The US is not necessarily making the wrong choice – its economy is more complex than others and its companies have more diverse financing needs. But it is a choice. As Thomas Sowell said, “There are no solutions. There are only trade-offs.”

4) Confidence is king

The fact that banking is a confidence game is of course no great secret. Marc notes that the problem in part is that confidence in the bank is largely based on proxies for soundness (e.g. capital and liquidity ratios, supervisory oversight, credit ratings) that have a history of being found wanting. So the foundations of confidence in your bank or the banking system as a whole are not themselves entirely reliable. A bank can tick all the boxes but still lose the confidence of the markets and find its viability subject to the (inherently risk averse) judgments of its supervisor and/or central bank.

The problem is exacerbated by the fact that it is difficult if not impossible to restore confidence once it is questioned. Marc restates Bagehot’s classic take on this question …

“If you have to prove you are worthy of credit, your credit is already gone”

Lombard Street: A Description of the Money Market; Walter Bagehot 1873

as follows …

It’s very difficult to restore confidence once it’s gone. One thing not to do is put out a press release saying your liquidity is strong. You’d think people would have learned after Bear Stearns, but no. When the proxies cease to work, saying it ain’t so won’t help either. 

5) Nobody knows anything

Marc writes …

“The dirty secret among bank analysis is that it’s quite hard for an outsider to discern what’s going on inside a bank… It’s only after the the fact it becomes apparent what questions to ask.”

This is probably my personal favourite because I was a bank insider for close to four decades and now I am looking at banks from the outside (hence the name of my blog). I like to think that I learned a bit about banking over that time but mostly what I learned was that banks are really complex beasts and I am still learning new things now. Hats off to anyone who really understands banking without having had the benefit of working on the inside or having the access to talk to people working on the front line of banking.

So what

Marc’s observations accord with my experience so I recommend his post for anyone interested in banking. Banks are one of the core institutions of our economy and our society so understanding them is I think important. Even if you don’t agree with him (and me), his post offers a useful reference point for checking your perspective.

If you want to dig further then there are couple of posts on my blog (see links below) that dig into these questions based in part on my experience but also summarising useful papers and other insights I have come across in the as yet incomplete quest to understand how banks do and should operate.

Tony – From the Outside

Links:

Deposit insurance

I recently flagged a post by Patrick McKenzie on the mechanics of the humble bank deposit. Patrick has followed that with another equally interesting discussion of deposit insurance. The post is written as a high level primer and so it does not offer any insights to anyone already familiar with the topic.

The main thing that grabbed my attention was Patrick’s emphasis on the “information insensitive” nature of bank deposits. This to my mind is a fundamental concept in analysing bank deposits but gets way less attention that I think it deserves. It is particularly important when you are looking at the question of the extent to which deposit insurance promotes moral hazard.

So it was good to see someone else promoting the importance of this concept. On the other hand, his discussion of the information insensitivity of deposits does not give as much attention to the role of “deposit preference” as I think it deserves. It is always possible of course that I have this wrong but, for me at least, the preferred claim that many jurisdictions afford bank deposits is a key part of understanding why bank deposits can be information insensitive” without necessarily creating moral hazard.

If you are interested to dig deeper ….

  • Matt Levine did a good post on the overall question of how finance uses tranching to turn a pool of risky assets into a mix of safe and risky claims on those assets where he described this as “A main move in finance” (see here for my summary of the column if you don’t have access to his column)
  • There is also a page on my website where I discuss the arguments for protecting depositors (the “why”), another where I attempt to dig a bit deeper into the technical aspects of bank deposit protection (the “how”), and this post offering an Australian perspective on the process of how bank deposits (a loan to highly leveraged company) get turned into mostly risk free assets in the hands of bank depositors.

Tony – From the Outside

Matt Levine on stuff that gets lost in translation

I have been referencing Matt Levine a lot lately. No apologies, his Money Stuff column is a regular source of insight and entertainment for banking and finance tragics such as myself and I recommend it. His latest column (behind a paywall but you can access a limited number of articles for free I think) includes a discussion of the way in which the DeFi industry has created analogues of conventional banking concepts like “deposits” but with twists that are not always obvious or indeed intuitive to the user/customer.

We have talked a lot recently about how crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account.

Matt Levine “Money Stuff” column 28 June 2022 – Crypto depositors

How banks can create safe assets is a topic that I have looked at a number of times but this post is my most complete attempt to describe the process that Matt outlines above. To me at least, this is a pretty fundamental part of understanding how finance works and Matt also did a good post on the topic that I discussed here.

One of the key points is that the tranching of liabilities also creates a division of labour (and indeed of expertise and inclination) …

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.

The DeFi industry argues that they want to change the ways that traditional finance operates for the benefit of users but it also expects those users to be motivated and engaged in understanding the details of the new way of doing things. A problem is that some users (maybe “many users”?) might be assuming that some of the rules that protect depositors (and indeed creditors more generally) in the conventional financial system would naturally be replicated in the alternative financial system being created.

Back to Matt …

The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.

The problem according to Matt is ….

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.

This feels like a problem to me. As the industry becomes more regulated I would expect to see the issues of seniority and deposit protection/preference more clearly spelled out. For the time being it does seem to be very much caveat emptor and don’t assume anything.

Tony – From the Outside

A (the?) main move in finance

Matt Levine’s Money Stuff column (Bloomberg Opinion) had a great piece today which, while nominally focussed on the enduring question of “Looking for Tether’s Money”, is worth reading for the neat summary he offers of how finance turns risky assets into safe assets. The column is behind a paywall but you can access it for free by signing up for his daily newsletter.

This particular piece of the magic of finance is of course achieved by dividing up claims on risky assets into tranches with differing levels of seniority. In Matt’s words…

Most of what happens in finance is some form of this move. And the reason for that is basically that some people want to own safe things, because they have money that they don’t want to lose, and other people want to own risky things, because they have money that they want to turn into more money. If you have something that is moderately risky, someone will buy it, but if you slice it into things that are super safe and things that are super risky, more people might buy them. Financial theory suggests that this is impossible but virtually all of financial practice disagrees. 

Money Stuff, Matt Levine Bloomberg, 7 October 2021

Matt also offers a neat description of how this works in banking

A bank makes a bunch of loans in exchange for senior claims on businesses, houses, etc. Then it pools those loans together on its balance sheet and issues a bunch of different claims on them. The most senior claims, classically, are “bank deposits”; the most junior claims are “equity” or “capital.” Some people want to own a bank; they think that First Bank of X is good at running its business and will grow its assets and improve its margins and its stock will be worth more in the future, so they buy equity (shares of stock) of the bank. Other people, though, just want to keep their money safe; they put their deposits in the First Bank of X because they are confident that a dollar deposited in an account there will always be worth a dollar.

The fundamental reason for this confidence is that bank deposits are senior claims (deposits) on a pool of senior claims (loans) on a diversified set of good assets (businesses, houses). (In modern banking there are other reasons — deposit insurance, etc. — but this is the fundamental reason.) But notice that this is magic: At one end of the process you have risky businesses, at the other end of the process you have perfectly safe dollars. Again, this is due in part to deposit insurance and regulation and lenders of last resort, but it is due mainly to the magic of composing senior claims on senior claims. You use seniority to turn risky things into safe things

He then applies these principles to the alternative financial world that has been created around crypto assets to explore how the same factors drive both the need/demand for stablecoins and the ways in which crypto finance can meet the demand for safe assets (well “safer” at least).

The one part of his explanation I would take issue with is that he could have delved deeper into the question of whether crypto users require stablecoins to exhibit the same level of risk free exchangeability that we expect of bank deposits in the conventional financial world.

Matt writes…

The people who live in Bitcoin world are people like anyone else. Some of them (quite a lot of them by all accounts) want lots of risk: They are there to gamble; their goal is to increase their money as much as possible. Bitcoin is volatile, but levered Bitcoin is even more volatile, and volatility is what they want.

Others want no risk. They want to put their money into a thing worth a dollar, and be sure that no matter what they’ll get their dollar back. But they don’t want to do that in a bank account or whatever, because they want their dollar to live in crypto world. What they want is a “stablecoin”: A thing that lives on the blockchain, is easily exchangeable for Bitcoin (or other crypto assets) using the tools and exchanges and brokerages and processes of crypto world, but is always worth a dollar

The label “stable” is a relative term so it is not obvious to me that people operating in the crypto financial asset world all necessarily want the absolute certainty of a coin that always trade at par value to the underlying fiat currency. Maybe they do but maybe some are happy with something that is stable enough to do the job of allowing them to do the exchanges they want to do in risky crypto assets. Certainly they already face other costs like gas fees when they trade so maybe something that trades within an acceptable range of par value is good enough?

What it comes down to is first defining exactly what kind of promise the stablecoin backer is making before we start down the path of defining exactly how that promise should be regulated. I do think that the future of stablecoins is likely to be more regulated and that is likely to be a net positive outcome. The term “stablecoin” however encompasses a wide variety of structures and intended uses. The right kind of regulation will be designed with these differences in mind. That said, some of the stablecoin issuers have not done themselves any favours in the loose ways in which they have defined their promise.

Matt’s column is well worth reading if you can access it but the brief outline above flags some of the key ideas and the issues that I took away. The ways in which seniority in the loss hierarchy creates safety (or what Gary Gorton refers to as “information insensitivity”) is I think the key insight. I frequently encounter papers and articles discussing the role of bank deposits as the primary form of money in developed economies. These nearly always mention prudential regulation, supervision and deposit insurance but the role of deposit preference is often overlooked. For anyone looking to dig a bit deeper, I did a post here offering an Australian perspective on how this works.

Tony – From the Outside

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, had (at the time this post was written) a distinctly different approach to bank deposits that not only eschews 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 your 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