Date created:14 September 2002
Last modified: 14 September 2002
Maintained by: John Quiggin
John Quiggin

Savings need a safety net

Australian Financial Reviee

29 August 2002

As the various insurance crises grind on, it is useful to take a step back and consider some of the broader lessons. Failures of prudential regulation in insurance have important implications for banking regulation.

As many holders of insurance policies were surprised to discover, the government regulates insurers, and imposes a wide range of compulsory insurance requirements on members of the community, but does not guarantee that the resulting policies will be honoured.

Most Australians would be even more surprised to discover that there is no public guarantee of bank deposits. Under current policies, the government does not guarantee deposits, but does nothing to dispel the general belief that such deposits are absolutely safe.

The apparent rationale for this position is twofold. First, it appears to preserve maximum discretion for the authorities to manage any future banking crisis as they see fit. Second, there are a range of objections to any alternative policy, such as deposit insurance.

The recent insurance crises show that the idea of preserving discretion is nonsense. In the panic that necessarily accompanies a crisis, the absence of an ironclad guarantee naturally leads the public to focus on the worst-case scenario. The difficulty the government had in persuading surgeons to keep operating after the collapse of United Medical Protection illustrates this point.

But the medical insurance panic would be nothing compared to what might happen if, in the midst of a liquidity crisis at a major bank, one of our socially responsible talk-show hosts suddenly discovered that there was no government guarantee for bank deposits. This happened on a small scale in the 1970s, forcing NSW Premier Neville Wran to take a loudhailer into the streets to stop a run on a building society.

Once a panic of this kind is under way, any equivocation on the government's part is fatal. Once again the disastrous experience of state regulated building societies provides an example. When the Pyramid group got into trouble in Victoria in the early 1990s, the Cain Labor government tried to hedge its bets on whether deposits would be guaranteed. The resulting climate of panic helped to bring down both the government and the Victorian economy. And, in the end, the government had to pay out anyway.

Even with a prompt and unequivocal response, situations like this raise the question of where lines are to be drawn. If ordinary bank deposits are guaranteed, what about certificates of deposit? If certificates of deposits are included, what about the share parcels marketed by banks? What about the 'Mum and Dad' shareholders of the bansk themselves? The only way to prevent panic is to spread the safety net as wide as possible, and far wider than would have been required with an explicit, and explicitly limited, guarantee.

Many of these problems would arise to some extent even in the presence of an explicit system of deposit insurance. But nearly of the problems with deposit insurance, such as moral hazard, apply in spades to the implicit insurance in force in Australia.

The real reason we do not have deposit insurance is that the big banks are unwilling to pay for it. The main cost is not the premium but the more intrusive regulation that would obviously be justified once the government was explicitly identified as an insurer.

One might ask how such a situation could arise, given that the whole system of prudential regulation was reviewed by an eminently-qualified commitee (the Wallis committee) as recently as 1997. In fact, the Committee's 1996 Discussion Paper did suggest looking at deposit insurance, but the idea was howled down so effectively that it made no appearance in the final recommendations.

In principle, a deposit insurance scheme could be run either by the government, as in the United States, or by a private insurer, as in Germany. For expert advice on the options, I spoke to Ian Harper of Melbourne University, Australia's leading banking economist and a member of the Wallis committee. Harper's view was that private deposit insurance could play a useful role as a 'front-line' of defence against minor problems, particularly those affecting smaller institutions. However, the Big Four banks are too big for reinsurance, and too few in number for mutual insurance on the German model. Hence, the system must ultimately be guaranteed by government.

In the current atmosphere of global financial crisis, a banking panic could emerge with very little warning. The sooner Australia moves to an explicit system of deposit insurance, the better.

Professor John Quiggin is a Senior Research Fellow of the Australian Research Council, based at the Australian National University and Queensland University of Technology.

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