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Imagine you woke up one day to find your bank account had been wiped out.

Your entire life savings has evaporated overnight, but not because some anonymous fraudster had stolen it.

It happened because the very banking institution that regulators have repeatedly told you is “unquestionably strong” has faltered.

The bank has taken your deposit and converted it into shares to ensure its own survival.

Banks move to 'bail-in' your money.

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A Senate inquiry is being asked to consider whether there is need to tighten up a “loophole” that could give APRA the power to “implement, authorise or direct bail-in to deposit accounts”..

Bank deposit insurance: Is your money safe and at what price?

Stephen King, Monash University

How safe is your money?

In October 2008, at the height of the Global Financial Crisis (GFC), the federal government decided to guarantee bank deposits. The ‘financial claims scheme’ (FCS), was an emergency measure to protect the banking system.

Initially, deposits up to $1m at ‘authorised deposit-taking institutions’ (ADIs) were insured by the government at no charge. From February 1, 2012, the cap was dropped to $250,000 per person per institution. The government also had a scheme to guarantee large deposits that finished on 31 March 2010.

Government deposit insurance is new in Australia. Traditionally, bank deposits were not insured. If a bank went belly-up, depositors joined the queue along with other unsecured creditors. Their protection was that they jumped to the front of the queue.

But the GFC showed that bank deposits were, for all practical purposes, insured. Politically, the federal government could not allow depositors to face the risk of bank bankruptcy. They had to intervene. Hence, Australian deposit insurance was born.

This was not a surprise. Experience had shown that governments could not stand aside and let the market work when voters had money at risk. As the Reserve Bank of Australia (RBA) noted, if a bank failed:

“[T]he Government would be under pressure to make an ad hoc response, as was demonstrated by the failure of the general insurer HIH in 2001”.

The government had announced the introduction of a form of deposit insurance in 2008 but the GFC beat them to it. And we had an ad hoc policy response.

The current FCS covers about 99 per cent of deposit accounts in full. But it has some features which, at a minimum, need to be debated.

The FCS provides insurance to banks but does not charge them an insurance premium. If a bank fails the government pays out insured deposits and recovers the money, first from the failed bank and then through a levy on other banks.

This is odd.

It means that banks receive a benefit that they do not pay for. Deposit insurance benefits the banks. It makes it easier for a bank to raise funds and compete with other financial institutions that are not insured by the government.

Deposit insurance also has a ‘dark side’. It encourages banks to take risks. So the FCS must be accompanied by strong regulatory intervention through the Australian Prudential Regulation Authority (APRA). Australia has strong regulation but even the best regulation can be gamed.

An alternative is to charge the banks for their insurance. That charge could depend on the risk of bankruptcy. The more risky the bank, the higher the charge. Indeed, that is exactly what the government did with the guarantee on large deposits during the GFC.

While a risk-rated premium improves banks’ incentives, it doesn’t improve depositors’ incentives.

Martin Byford and Sinclair Davidson from RMIT have looked at this problem and come up with a novel solution. APRA could explicitly rate the banks. The payout that depositors receive under the FCS if their bank defaults would be directly related to that rating. If your deposits are in a riskier institution, then you get less protection than if they are in a safer institution. Indeed Byford and Davidson suggest a simple linear scheme.

“[A] depositor with $10,000 deposited in a ‘93’ rated bank [out of 100] would be guaranteed to receive $9,300 in the event of a bank failure”.

The scheme creates an explicit measurement of bank risk and gives incentives to both depositors and financial institutions. If you are a risk averse depositor you may only look at a high-rated bank. But such a bank will pay a low interest rate. Other depositors may be willing to take more risk, but lower-rated institutions will have to pay depositors a higher interest rate to attract their funds.

So the Byford and Davidson scheme combines flexibility with strong incentives.

To work, however, the government would need to be able to let depositor/voters lose some of their money if they put funds in a risky institution that goes bankrupt. This may be easy for small ADIs but harder for a ‘too big to fail’ major bank.

While the Byford and Davidson scheme may not have all the answers, we at least need a debate on the issues.

Currently the banks receive ‘free’ insurance that is not tied to their underlying risk. At a minimum, creating better incentives through an up-front risk-based premium with more depositor information and incentives would be a useful adjunct to APRA’s regulation.

The RBA’s argument against upfront premiums is that they are unlikely to accrue to the point where the funds match the liabilities if a bank fails. This is true but irrelevant.

The point of a risk-based deposit insurance premium is to provide good incentives to banks and depositors.

The current insurance scheme cross subsidises risky banks. If a bank takes increased risks with their funds then they pay no more for insurance despite the increased risk. In contrast, when the insurance premium increases with risk, banks face an explicit cost when they take risky actions.

The current FCS also removes any incentive for depositors to monitor their bank’s level of risk. It is a one size fits all scheme. Even if a depositor was happy to take more risk (with a higher rate of return), the depositor couldn’t do so. So the current deposit insurance arrangements encourage banks to take increased risk and take away the incentive for depositors to find out about that risk. It places all the responsibility for the security of the financial system back on APRA and makes APRA’s job harder. To me, that doesn’t sound like the way to design a deposit insurance scheme.The Conversation

Stephen King, Professor, Department of Economics, Monash University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

Coronavirus crisis heightens fears bank deposits could be wiped out under ‘ambiguous’ laws

Imagine you woke up one day to find your bank account had been wiped out.

Your entire life savings has evaporated overnight, but not because some anonymous fraudster had stolen it.

It happened because the very banking institution that regulators have repeatedly told you is “unquestionably strong” has faltered.

The bank has taken your deposit and converted it into shares to ensure its own survival.

You now own those shares, but you’ve taken on more risk than you signed up for, and there’s a possibility those shares could end up being worthless.

This is a scenario of a bank moving to ‘bail-in’ your money.

If you think this totally impossible, think again. It happened in Cyprus not so long ago.

While a bail-in situation in Australia is currently a highly improbable scenario, people are feeling more nervous about their financial future amid the coronavirus crisis and deepest recession since the Depression.

A Senate inquiry is now being asked to consider whether there is need to tighten up a perceived legislative “loophole” that could give the nation’s banking regulator, the Australian Prudential Regulation Authority (APRA), the power to “implement, authorise or direct bail-in to deposit accounts”.

Is Australia at risk of an imminent ‘bail-in’?

Before understanding the history behind the current Senate inquiry, it is worth noting Australian banks are not in the same boat as the Cyprus banks were in 2013.

Our banks are still well-capitalised and profitable and are being supported by regulators throughout the COVID-19 crisis.

Furthermore, should their situation deteriorate because of the pandemic, the Federal Government has repeatedly vowed it will protect Australians’ bank deposits.

Under the Financial Claims Scheme, Australians’ savings with authorised deposit-taking institutions (ADIs) are guaranteed for deposits up to $250,000 per institution (if someone has two different accounts with the same bank, even if under different brands, the limit applies).

This deposit guarantee effectively commits the Government to the opposite of a ‘bail-in’. It is a ‘bail-out’.

It is also highly political unpalatable, and therefore extremely unlikely, that APRA would move to direct banks to bail-in people’s deposits.

Afterall, a core part of APRA’s mandate is to protect the interests of depositors, policyholders and superannuation fund members.

And, as the Cyprus case showed, retaining the confidence of retail depositors during a crisis is crucial to avoiding wider financial contagion.

Nevertheless, the mortgage loan book of Australian lenders has risen to almost $2 trillion.

And, as many economic commentators and the International Monetary Fund (IMF) have warned for years, if property values suddenly plummeted, that could turn into a huge liability and pose a risk to banks and the wider financial system.

Pedestrian walks past Reserve Bank building in Sydney
Australian banks are still well-capitalised and profitable, and are being supported by regulators throughout the COVID-19 crisis.(Reuters/file)

How a law change could explicitly prevent ‘bail-ins’

So, how did the Senate inquiry come about and what is it examining?

One Nation Senator Malcolm Roberts has introduced a proposed law change called the Banking Amendments (Deposits) Bill 2020, which was referred to the Senate Economics Legislation Committee in June.

In his words, “the bill stops failed banks taking our money”.

The fear about legislative loopholes initially surfaced following the GFC when a number of concerned individuals with links to the far-right political party Citizens Electoral Council (CEC) started writing letters to their local MPs.

The party is accused of being affiliated with the international LaRouche Movement, which was led by American political activist Lyndon LaRouche, who critics described as a political cult that promotes conspiracy theories and antisemitism.

The CEC, including its research director Robert Barwick, were asking for changes to the law that enshrine that their deposits are in fact safe, following legislation known as the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017.

This legislation gave APRA the power to allow a bail-in financial instrument known as “hybrid securities”, a financial instrument described at the time by former ASIC chairman Greg Medcraft as “a ticking time bomb”.

ASIC chairman Greg Medcraft
Former Australian Investment and Securities Commission (ASIC) chairman Greg Medcraft had described “hybrid securities” as a ticking time bomb.(AAP: Julian Smith)

Around that time, the Senate Standing Committee on Economics, which was chaired by Senator Jane Hume, examined the law surrounding bail-in of hybrid securities.

It said it did “not consider that the bill would allow the ‘bail-in’ of Australians’ savings and deposits” since “depositors are protected both by the FCS and under the Banking Act”.

The legislation passed in 2018.

Now fast-forward to 2020, with fears of a financial meltdown heightened as Australians lose their jobs, JobKeeper payments about to taper off and bank loan repayment holidays coming to an end.

The Senate has already been hit with about 200 submissions — mostly from self-funded retirees and older Australians who have accumulated life savings and therefore have large deposits in the bank.

These submissions all run along a similar theme: the need to remove all legislative uncertainty to stop “the legalised theft of bank depositor’s savings”.

For these citizens, in the aftermath of the banking royal commission, verbal assurances from APRA, the Reserve Bank of Australia and political leaders just aren’t enough.

They say if the Government and regulators are serious about protecting peoples’ deposits, there should be “no ambiguity” in the law. They want the Banking Act amended.

Pauline Hanson stands smiling beside Malcolm Roberts.
One Nation senators Pauline Hanson and Malcolm Roberts have proposed the Banking Amendments (Deposits) Bill 2020.(ABC News)

Those who argue law is ‘ambiguous’ rely on one legal opinion

So is the current legislation ambiguous?

Most of the individual submissions that argue the law is vague and are in support of the Bill passing, rely on one legal opinion. That of Robert H Butler, a solicitor from Chatswood in Sydney, and a member of the Citizens Electoral Council.

Mr Butler points out two problems with the existing laws.

Firstly, he says the 2018 Act that allows bail-ins of hybrid securities, in referring to them, also uses the words “any other instrument” without defining what this means.

Mr Butler argues that bank deposits could be “other instruments”.

He acknowledges that “the Government has contended that these words do not extend to deposits” but says “the reference to ‘any other instrument’ would be unnecessary if the power only applied to instruments with conversion or write-off provisions”.

Secondly, Mr Butler argues, that even if the words ‘any other instrument’ don’t encompass deposits, the banks themselves could change certain terms and conditions and draw on deposits.

Treasury says Bill is ‘unnecessary’

Treasury and the Australian Bankers Association have swiftly rejected the argument that the law is ambiguous.

Treasury says in its submission that it “considers the Bill to be unnecessary”.

It says there are currently two explicit legislative provisions in the Banking Act specifically directed to protecting deposits.

“First, section 13A(3) of the Banking Act provides for priority repayment of ‘protected accounts’ (including ‘deposit accounts’ within the meaning of the Bill) in the unlikely event that an ADI were unable to meet its obligations,” it said.

“Secondly, Part II, Division 2AA of the Banking Act establishes the FCS. The FCS guarantees protected accounts (including ‘deposit accounts’ within the meaning of the Bill) up to a cap of $250,000 per account holder, per ADI.”

Treasury also says the reference to “other instruments” relates to the theoretical possibility of APRA recognising other classes of capital instruments in the future.

“Importantly, the reference to ‘other instrument’ could never relevantly apply to deposit accounts, because … the contractual terms of deposit accounts invariably provide for full repayment of principal and interest (subject to fees).”

Federal Treasury building in Canberra
Treasury argues there are two explicit legislative provisions in the Banking Act specifically directed to protecting deposits.(ABC News: Kathleen Dyett)

Ex banking lobbyist says deposits should be up for grabs

Interestingly, some argue the Bill should be changed to do the exact opposite: the Banking Act should make it explicit that bank deposits are at some risk of write-off or conversion to shares.

Nick Hossack, a public policy consultant, former policy director at the Australian Bankers Association and former adviser to John Howard, is making that argument.

Mr Hossack argues bank shareholders and executives “have financial incentives to take levels of lending risk that exceed the socially optimal level of risk”.

“The Bill in effect shifts bank lending risk back onto taxpayers,” he said.

With smaller banks, there was a “feasible option of government authorities allowing a failure and putting the bank through an insolvency process where there is at least some risk that depositors will lose money”.

But allowing a failure of big banks was “not a realistic option”.

An NAB bank building is pictured in Sydney
Nick Hossack says the law should make it explicit that bank deposits are at some risk of write-off or conversion to shares.

Could banks change terms and conditions against depositors?

Martin North from research firm Digital Finance Analytics, together with former Liberal economic adviser John Adams, have been making regular YouTube videos on the possibility of a bail-in.

Both Dr North and Mr Adams argue, in separate submissions, that big banks have already changed their terms in the past few years.

For example, one big bank states that, “we may give you a shorter notice period, or no notice of an unfavourable change if we believe doing so is necessary for us to avoid, or reduce, a material increase in our credit risk or our loss”.

This, both Dr North and Mr Adams argue, allows the banks to, without notice, change conditions of these accounts to potentially activate deposit bail-in at the request of the regulators – essentially a bail-in.

He added that a bail-in is something that would occur before a bank fails, and so government deposit guarantees ($250,0000 per institution and customer) would not be activated.

A man in a grey jacket and striped blue shirt gestures with his hands.
Martin North says banks can change terms and conditions of accounts to potentially activate deposit bail-in at the request of the regulators.(ABC News)

Why global regulators support ‘bail-in’

The possibility of a bail-in in Australia needs to be viewed in a wider global context.

Following the 2008 financial crisis, international regulators have consistently argued that governments need to have clear policies on bail-in.

These policies don’t necessarily relate to deposits, but wider financial instruments designed to be converted into shares in the event of a crisis.

Firstly, the 2019 IMF Financial System Stability Report calls on authorities to introduce a “statutory bail-in regime, based on best international practice”.

Secondly, the G20-backed Financial Stability Board, which is charged with monitoring and assessing vulnerabilities affecting the global financial system, recently released a report evaluating the “too-big-to-fail” banking reforms.

The report suggests “governments must have the powers, the information and the incentives to move from bailout to bail-in”.

It explicitly states that this would involve giving authorities (in Australia’s case APRA) independent legal power to resolve a banking crisis without the consent of the banks, shareholders and their customers.

While the IMF does not define what ‘best international practice’ looks like, Dr North and Mr Adams note in their submissions that international examples of ‘statutory bail-in’ do already exist in New Zealand, the European Union, the United States and Canada.

Rally in front of NY Stock Exchange
Following the 2008 financial crisis, international regulators have consistently argued that governments need to have clear policies on bail-in.(Spencer Platt: Getty Images: AFP)

Transparency is key in an uncertain world

In a world where financial risks are heightened, regulators and political leaders need to be transparent.

Just days ago, chairman of the Financial Stability Board, Randal K. Quarles, delivered a speech warning that while too-big-to-fail banking reforms have strengthened the global financial system since the 2008 crisis, regulators should improve how they deal with the possibility of distressed banks.

He did not specifically mention ‘bail-in’, but noted in the aftermath of COVID-19, all FSB members — made up of 24 central banks including the Reserve Bank of Australia — need to consider how to “improve their resolution capabilities so they are fully prepared to respond to a bank failure or a crisis”.

This global discussion about bail-in policies coincides with the Federal Government’s proposal to introduce laws that would ban cash transactions above $10,000 and make it a criminal offence to use cash for most transactions above that limit.

It also comes at a time when there’s been evidence of wealthier Australians pulling large sums of cash out of their bank accounts.

The inquiry is due to report back in early August. It may well find that there is no institutional risk of a bail-in in Australia.

That being the case, the perception that there is legal ambiguity could be further tested if the inquiry holds public hearings that include the views of others, including independent legal experts.

Politically, it is likely the Government will remain reluctant to change the law to more clearly state there will not be bail-ins.

Such a move could send a signal to the wider community that it feels there is a risk and that might spook the public into a bank run, where a large number of people rush to pull out their deposits.

But depositors need to be provided with clear information so that they are aware of the risks they face in the event that a worst-case scenario eventuates.

Only then can they make informed decisions about what they do with their money.

Article originally published by the ABC