New Zealand Needs Deposit Insurance

New Zealand will be the only member country of the OECD area that does not have deposit insurance for bank customers once Australia introduces a scheme it announced in June to guarantee up to A$25,000 of bank deposits.

With European countries such as Germany extending a blanket guarantee to all personal deposits in recent days, the pressure on countries without deposit insurance schemes will mount to introduce some form of guarantee to reduce the risk of capital flight to banking systems where deposits are insured.

In New Zealand's case, the risk is of trans-Tasman capital flight to Australian insured deposits in times of financial instability that could further squeeze the availability of credit in New Zealand's banking system. Such disparities in deposit insurance schemes has seen British funds transferred into guaranteed deposits in Ireland. Moreover, since New Zealand's major banks, referred to as "the trading banks", are Australian-owned, an uneven deposit regime would likely create perverse incentives for the parent companies in relation to their NZ subsidiaries.

Deposit insurance in the United States has prevented runs on banks since the mid 1930s. Recent financial collapses in the US have occurred in those parts of the financial sector outside the FDIC-insured deposit sector. Banks holding insured deposits are subject to greater regulation than the investment banks and others that have become insolvent after trading rashly, and some fraudulently, in off-balance sheet financial derivatives that are poorly regulated.

The US policy error in the early 1980s was to socialise the liabilities (deposits) of savings & loan associations (saving banks) by escalating the amount insured per account but to deregulate or privatise the assets side of their balance sheets. The ensuing mayhem in the casino economy that US policymakers created ended in the savings & loan crisis in the mid to late 1980s.

Many of the current crop of bank failures were among those who scavenged the insolvent thrifts and turned them into peddlers of financial innovations encompassed under the umbrella term financial derivatives. The Federal Reserve under Greenspan helped things along by weakening the application of Glass-Steagall Act controls on asset management of commercial banks put in place to prevent some of the excesses of the Great Depression. Glass-Steagall was ultimately repealed by the Gramm-Leach-Bliley Act in 1999 wherein some of the seeds of the current US financial crisis may be found.

In the US, the solution is to re-regulate asset management. In New Zealand, the Reserve Bank apparently exercises effective prudential supervision of the trading banks, but the solution to minimizing the risk of systemic financial instability likely involves a deposit insurance scheme.

The Reserve Bank and other policymakers are supposedly concerned about the moral hazard problem if deposit insurance were to be introduced - that knowing deposits were guaranteed, bankers would engage in reckless lending activity. First of all, in the New Zealand banking culture, banker behaviour is relatively conservative given the dominance of the trading banks. Second, worrying about moral hazard when the horse has bolted from the global banking stable is not the time, as financier George Soros says, to be concerned about it: the systemic crisis must be dealt with decisively and effectively now to avoid deflation and broad economic collapse.

Finally, New Zealand has a long and undistinguished history of strategy switching when it comes to policy. The economic tsunami of the Great Depression, THE crisis of modern times, precipitated - eventually - a Labour-led welfare state of economic "insulation" - regulation & trade protection - combined with the broad development of social services. In the mid 1980s, a balance of payments and currency crisis unleashed free market reforms and fiscal & monetary austerity not seen since the 1920s. In short, policy development in New Zealand has been all too often ad hoc and reactive in nature to some economic or political crisis. The real challenge of strategy switching is to shift policy regimes when economic times are prosperous, when policy can be developed with reflection and full participation, not in haste, under the gun.

Central banking and financial regulation have been of that nature too. The Reserve Bank was only established in 1934, relatively late in the piece for developed countries, with New Zealand's own currency being issued for the first time in that year. The free market policies of the past twenty-five years combined with the Reserve Bank being charged with the primary responsibility of achieving price stability, have exposed the New Zealand economy to the full winds of the global market economy. In a curious irony, policymakers that have championed free markets ignored the fact that however well the New Zealand economy might perform - and it has continued to be mediocre by international standards - as a small, open economy it would have to respond to whatever policy regimes larger nations might follow.

An obsolete ideology has entrapped the nation in an economic web that exposes it to periodic systemic destabilization of the economy, polity, and society. The lesson learned by Kiwis in the 1930s has been forgotten by those in the early 21st century. Kiwis today are about to be taught the lesson once again because a careful knowledge of history is not something ideologues are known for.