Should the Australian government continue to guarantee bank deposits?

In a recent post I suggested that government guarantees of bank deposits tend to encourage banks to become highly geared because they make depositors less cautious about depositing their funds with banks that are at greater risk of default. Such guarantees could be expected to make it possible for highly geared banks to obtain access to deposits at lower cost than would otherwise be possible.

A regular reader of the blog, kvd, objected to my reasoning. In his comments he suggested:

 'your acceptance that 'the market' should play any part in the securitisation of depositors' funds (alongside equity participants) offends against my own beliefs. …

I would not seek in any way to regulate or limit the rich investing their money in any way they wish. But government failure to differentiate between the basic needs of their populace, and the desires of a relatively small, select group of players - that I find a complete abrogation of a basic government role - more specifically, a responsibility.

By all means let's limit government involvement and guarantee - but let's first more clearly delineate what it is that government should be obliged to protect.' 

In the subsequent discussion kvd clarified that what offended against his beliefs was the idea that depositors should be expected to take account of differences in the risks involved in placing their funds in different institutions. 

He explained his position further in a later comment:

 'My interest was initially piqued by what I referred to as the 'securitisation' of a significant part of the funds sources available to banking institutions - namely those funds deposited in the ordinary course of getting on with one's life. If you accept my figures, this amounts to somewhere north of 20% of the funds available for them to pursue their objectives.

While I would be the last to suggest any of the 'big four' are in danger of collapse, I do think that in your higher level analysis of 'marketplaces' and 'risk assessment' it begs the question as to just what is represented by the 20+% of unsecured creditors (because that's effectively how depositors' funds are treated; and that's why there were recent queues outside various high street banks and building societies in the UK) which I termed 'transactors'.

My simple point remains that these funds should be regarded more as the old fashioned 'Trust Fund' one sees in any solicitors' practice. Yet that is not where they presently sit in calculation of leveraging. Within that they are subsumed in those funds available to satisfy any higher-secured obligation. Except for shareholders, they are in fact last in the queue, along with any other trade creditor.

When one thinks of such funds, Winton mentions the 'mum and dad investor'; the implication being that the sums are small, difficult to manage, an annoyance really in terms of transaction costs. [Editorial note: I didn't intend to imply that the sums are small or an annoyance to banks.]

But when I think of those funds I'm referring to my working cheque account …  . These funds are sloshing around in the banking system, available (God forbid) at any time for our banks to satisfy secured creditors. Come a crunch, my funds are essentially an unsecured interest free loan to my bank, available for them to pursue (did you term it?) enhanced shareholder returns.

Too much regulation involved to protect such funds? I'd suggest a reclassification of such funds as first charge government backed liability. Would that would necessitate a recalculation of the risk attaching to other funding sources? Yes, and so be it; the market will decide that.'

Before considering the question of bank guarantees, I will first attempt to consider whether it would be possible or sensible to make the status of bank deposits more like that of solicitor's trust funds. I write 'attempt' because my knowledge of the law concerning solicitor's trust funds is rudimentary. My understanding is that solicitor' trust funds remain the property of the client. There is a great deal of regulation about what solicitors can do with those funds but I expect that they would normally be deposited in a trust account at a bank. That would probably be the safest thing to do with them, even though the funds might still be at risk in the event of bank failure. Perhaps that risk might be covered by solicitor's insurance, I don't know.

The underlying point that kvd is making seems to be that, in the event of default, depositors should be accorded the same ranking as secured creditors. My immediate reaction was that it might be difficult to give depositors a lien over a bank's loan portfolio, but further thought led me to the view that there is nothing to prevent bank deposits from being secured by a lien over other bank assets such as holdings of government securities.

The idea of giving a class of depositors a lien over a bank's holdings of a particular class of assets makes a lot of sense to me. In the absence of government guarantees, this could be expected to be most attractive in relation to transaction accounts of those depositors who are most concerned about security. As at present, such deposits would earn little or no interest and transactions charges would apply. The important point is that these deposits could be expected to be fully covered against loss in the event of bank default – unless, of course, shits are trumps and bank default is caused by default by governments (in which case, government guarantees would also be worthless).  

So, let us now consider whether the government guarantee of deposits should remain in place. Some recent history might help.

Banking in Australia functioned without a government guarantee of deposits prior to the global financial crisis. The Wallis report into the financial system (1997) recommended against the introduction of government-backed deposit insurance on the grounds that it 'was not convinced that such a scheme would provide a substantially better approach or additional benefits compared with the existing depositor preference mechanism' (p355). According to Wallis, the depositor preference mechanism 'provides that the assets of a bank shall be available to meet depositor liabilities prior to all other liabilities of the bank' (p 354).

An article on depositor protection by Grant Turner (RBA Bulletin 2011) suggests that the recommendation against deposit insurance by the Wallis inquiry 'reflected concerns that introducing deposit insurance could weaken incentives to monitor and manage risk' (p 49).

In my view such concerns are warranted. I can understand that depositor guarantees were considered desirable in the midst of the global financial crisis, but it would be good to be rid of them as soon as possible. The best way to phase out such guarantees would be to make them unnecessary by ensuring that governments will never be called upon to honour them. Could that be achieved by requiring that the guarantees will apply only to deposits that are secured by a lien on government securities held by deposit-taking institutions?

Postscript:

I have had second thoughts on the question of how the deposit guarantee should be removed.

My further discussion with kvd, see comments below, makes it clear that in the absence of the guarantee, deposits would rank after secured liabilities in the event of bank liquidation. This has become particularly important since the guarantee was made 'permanent' because the existence of the guarantee has been used as an excuse to allow banks to raise funds using covered bonds (i.e. secured liabilities).

It is probably reasonable to expect that if the deposit guarantee was removed, the market would eventually find a way to give demand deposits the highest priority in the event of bank liquidation. However, it might take some time before banks began to see it as in their interests to provide sufficient asset backing to demand deposits to enable that to occur.

It seems unlikely that any government would remove the guarantee unless it considered depositors to be adequately protected. I think that could be achieved by giving demand deposits the priority that is currently accorded to APRA in order to recover funds it pays to depositors under the current guarantee arrangement. As I understand the situation, the Banking Act gives debts and liabilities to APRA the highest priority in the event of bank liquidation.

In my view, legislation should give demand deposits the highest priority in the event of bank liquidation in order to maximize the potential for banks to be able to honour the promises that they make to allow depositors to withdraw such funds on demand. 

What questions should the 'science of morality' be seeking to answer?

In a recent article on Scepticblog entitled 'Towards a Science of Morality', Michael Shermer suggests: 'determining the conditions by which humans best survive and flourish ought to be the goal of a science of morality'. I agree, more or less, but see some problems with the reasoning he uses to get to that point, and urge him to consider more explicitly the questions that the science of morality should be seeking to answer or the problems it should be attempting to solve. (By the way, thanks to Steven Pinker for drawing attention to Shermer's article via Twitter.)

Shermer's first proposition is a 'principle of moral good': 

'Always act with someone else's moral good in mind …'.

Why? Perhaps I misunderstand, but that seems to imply that it is always good, for example, to sacrifice your health for the benefit of others. I can think of real world situations where in my judgement such conduct has not been good for either the actor or the recipient. I think an impartial spectator would say that it is good for people to act with some regard for their own needs as well as seeking to benefit others.

What is the basic moral principle? My answer is that we should always seek to act ethically. I guess that stems from a belief that moral instincts and a capacity for moral reasoning are part of human nature and exist for good reasons. Humans have a basic need to feel that they are acting ethically.

Shermer's second proposition is that to find out whether an action towards some other individual is right or wrong we should ask them. I agree. We should recognize the rights of other individuals (adults) to decide whether or not to accept proposed actions that are intended for their benefit. But that proposition seems to me to belong after establishing that 'the survival and human flourishing of the individual is the foundation for establishing values and morals'. Acceptance that we all begin our lives with a passion to survive and flourish seems to me to gives greater moral force to the observation that different individuals have different goals in life and a capacity to take responsibility (as adults) for decisions they make.

Is it defensible to argue that the survival and flourishing of the individual is the foundation for establishing values and morals? That seems clearly defensible if we think of the passion of humans to survive and flourish as a product of evolution. The moral intuitions of our ancestors could be expected to have pre-disposed them to favour theories of morality in which human flourishing is viewed as the purpose of life. It is also defensible if we think in terms of codes of morality and as the outcome of cultural evolution. As Hayek and others have suggested, those groups with codes of morality most conducive to individual flourishing – thou shalt not do things that infringe the rights of other individuals - have tended to be more successful.

If we accept that individual flourishing is the foundation on which our moral intuitions are based, does it necessarily follow that 'determining the conditions by which humans best survive and flourish ought to be the goal of a science of morality'. No! We can't derive an 'ought' statement from an 'is' statement. Nevertheless, there is nothing to stop us from feeling that there is a smooth transition between the two statements, or that the statements are closely aligned.   

As I see it, however, it is worth taking a step back to ask what our purpose is in asserting that some topic ought to be the goal of a science of morality. It seems to me that the purpose is to assert that the science of morality should be aiming to answer a particular question (or set of questions) or to solve some problem.

So, why not simply assert that the science of morality should be concerned with questions relating to human survival and flourishing? The assertion can be justified with reference to evolutionary considerations, by Aristotle's question about the chief good that is desired for itself rather than because it enables us to obtain something else, by introspection or other considerations. The important issue is whether the assertion is able to stand up to criticism.

One possible basis for criticism is that the science of morality should be concerned with questions relating to the survival and flourishing of other living things as well as humans. Perhaps that objection might be overcome by asserting that questions relating to human survival and flourishing are an important part of the science of morality.

However, that still leaves open the potential for confusion over the meaning of 'the science of morality'. What I think it means is that preferences relating to moral proposals should be based on their ability to stand up to criticism rather than that they are falsifiable. (That probably means rejection of the boundary that Karl Popper attempted to draw around science, but it is consistent with his broader views about the importance of criticism.) Some moral proposals involve value judgements that can be criticized, but cannot be proved wrong. Perhaps we can avoid confusion by further rephrasing our assertion along these lines:

Given the importance of human survival and flourishing it is important to for all questions relating to this topic to be fully explored, including the influence of values, social norms, constitutions, laws and regulations.

After asserting that the conditions by which humans best survive and flourish ought to be the goal of a science of morality, Shermer proceeds to provide examples of moral actions directed toward survival and human flourishing. These actions included reducing extreme poverty and facilitating economic growth and hence improvement in average levels of subjective well-being.

I agree with the examples that Michael Shermer provides, but having asserted the importance of exploring questions relating to human survival and flourishing it seems to me to be important to attempt to clarify the nature of the problem. In order to do so it would be appropriate to attempt to consider relevant questions in a sequence which recognizes that the way we answer one question may influence the way we frame subsequent questions.

For example, in Free to Flourish, my first set of question was about whether human flourishing should remain largely the responsibility individuals in voluntary cooperation with others, or whether it should be pursued primarily through government action directed toward achieving national goals. My answers to those questions led me to then consider the characteristics of societies that are most conducive to human flourishing. My answer to that question led to a consideration of the main drivers of progress and the greatest threats to progress.

How can governments stop encouraging banks to be highly geared?

A reader of my book, Free to Flourish, is puzzled by a brief comment I made about fundamental weaknesses in the financial system. He asks whether the following passage implies the existence of a fundamental market failure with respect to the financial system:

'The underlying incentives that the system provides for participants to take risks with borrowed funds might even tempt saints to behave imprudently. Another outbreak of gambling with borrowed funds will become increasingly more likely as memories of the recent crisis recede, unless fundamental reforms are introduced. Required reforms include the removal of any implicit guarantees that any financial institutions are 'too big to fail' - by taking action to penalise rather than assist the owners of financial institutions which are at risk of default - and removal of distortions in tax systems which favour debt funding relative to equity funding' (Chapter 8).

I accept that there may be market failure in the financial system. There can be negative externalities associated with bank failures. If the failure one bank leads to loss of confidence in some other banks, there may be a market failure involved. Then again, there may not be. If the failure of one bank leads to loss of confidence in banks that have taken similar risks, leaving other banks unaffected, it would be reasonable to argue that the market is just taking appropriate account of new information. Nevertheless, at an aggregate level, I accept that central banks may be able to play a useful role in sustaining expectations of ongoing growth in aggregate demand when bank failures occur.

However, my concerns about the fragility of the financial system – as it exists at present – cannot be attributed to market failure.

The following hypothetical example might help to begin to explain the nature of the problem as I see it. Let us focus on two banks competing in a free market, without government interventions. Both banks are the same in nearly all respects, but while Bank A is profitable, Bank B is having difficulty competing for deposits. The reason for this is that the level of shareholder equity in Bank A is relatively high and potential depositors feel that the interest rate being offered on deposits in Bank B (the same as for Bank A) would not adequately remunerate them for the additional risks they would be taking. 

There are several options that Bank B might consider to become more competitive. For example, it could offer a higher interest rate to reflect the greater risks involved for depositors; it could reduce the risks in its asset portfolio (perhaps by having a higher proportion of its portfolio in relatively safe government securities); or it could issue more equity capital and become more like Bank A. The optimal level of equity depends on factors such as the riskiness of the bank's asset portfolio and the extent to which depositors require higher interest to compensate for risk.

Is this example plausible? Is it conceivable that it might be possible in a free market for a bank to be profitable with a relatively high level of shareholder equity? Many would argue that the example I have given is unrealistic because an equity risk premium must be paid for access to equity capital. On that basis, it is argued that banks with relatively high equity could be expected to have a relatively high cost of capital and thus to be less profitable than banks with relatively low equity.

Anat Admati and three of her colleagues provided a pertinent response to the suggestion that increased equity would increase funding costs for banks in their paper: 'Fallacies, Irrelevant Facts and Myths in the discussion of Capital Regulation: Why Bank Equity is Not Expensive'.  These authors draw attention to the Modigliani-Miller (MM) analysis which shows that increases in the amount of equity relative to debt financing simply re-distribute risk among investors. The total funding cost is determined by the total risk that is inherent in the bank's asset portfolio and is independent of gearing. In that context, any losses from using less borrowed funds must be offset by the correspondingly lower cost of equity capital.

The essential assumption of the MM analysis - apart from the assumption (discussed below) of no government intervention favouring either debt or equity funding - is that investors are able to take account of portfolio risk and gearing when pricing securities. Admati et al make the telling point that banks make this assumption in managing their risks.

So, what happens if we relax the assumptions of the MM model by introducing a tax system that encourages debt relative to equity, a government guarantee that banks will not be allowed to fail and protection for depositors? We should expect to get banking systems that are highly geared and fragile – like our current banking systems.

How can governments remove those distortions?  The obvious answer is just do it! However, removal of the tax distortions will require major tax reforms in countries that have classical company taxes. The problem in relation to government guarantees and protection of depositors is that announcements  that they will no longer apply are not likely to be credible (except when made by governments that are so heavily indebted already that further bank bailouts would be impossible in any case).

Does that mean that the best option is for governments to regulate bank behaviour to such an extent that bank failure becomes highly improbable? That approach would suggest that if Basel III is not restrictive enough to make bank failure sufficiently improbable, we should be prepared to move on to Basel IV, and then Basel V, and even to nationalisation of banking if necessary.

At that point I begin to see red. If we are not dealing with a market failure, why are we attempting to displace the market? Is it really necessary to put the entire banking system into a regulatory strait jacket, with all the inefficiencies that involves, in order to live with the consequences of past regulatory failure? Would it not be possible for governments to make a credible commitment never to bail out another bank if they were prepared to spell out punitive action to be taken if regulatory agencies assess banks to be at risk of default? For example, why not announce plans for pre-emptive action to install administrators to restructure banks if they are assessed to be at risk of default?  

Postscript:

With the benefit of comments from kvd and Jim Belshaw (see below) it is clear that the line of argument presented above is not as clear as it could be and contains some unnecessary red herrings.

1.      The definition of banks. For the purposes of this discussion, the distinguishing characteristic a bank is that it is a company with relatively low shareholder equity and a relatively high proportion of debts repayable on demand. Later in the post, my focus is narrowed to financial institutions with deposits guaranteed by governments and/or viewed by governments as 'too big to fail'.

2.      The definition of externalities and market failure. The discussion in the paragraph immediately following the quote from Free to Flourish raises issues concerning the technical definition of externalities and market failure that are a largely a red herring from the perspective of the general line of argument I am developing here. All I needed to say was that while I acknowledge that there may be a case for government intervention based on the existence of market failure, that is not the basis for my concerns about the fragility of the banking system. (Nevertheless, the discussion is raising interesting points. There might be something wrong with our definition of market failure if new information about bank solvency that leads to the collapse of the banking system does not qualify as evidence of market failure. The question that kvd has raised about whether there is a case for government guarantees to cover use bank facilities for every day transactions using is alsoof interest to me. I will try to follow that up in a subsequent post.)

3.      My hypothetical example involving Bank A and Bank B. The example seems to have clouded the point I was trying to make, rather than illustrate it. The point the example was intended to illustrate is that in a free market banks would not have an incentive to seek ever-greater leverage. The rate of return on shareholder funds may rise as leverage increases, but depositors and shareholders would have an incentive to take account of the increasing risk of bank insolvency. As leverage increases the cost of borrowing additional funds could be expected to rise (i.e. the interest rate on deposits would need to rise). And at some point the increase in expected return on shareholder's funds will not be sufficient to compensate shareholders for the increased risk of failure of the firm.

4. Should the Australian government continue to guarantee banks deposits? That is the title of a later post in which I discuss issues raised by kvd.

Will 'Lincoln' encourage people to give more thought to modern forms of slavery?

Since seeing 'Lincoln', the movie, I have felt a need to find out more about modern versions of slavery – often described as human trafficking and debt bondage. Why? The movie made me feel that as author of a book entitled Free to Flourish and of this blog about freedom and flourishing, I should be making more of an effort to come to understand the issues involved in modern versions of slavery and similar restrictions on liberty.

'Lincoln' is basically about wheeling and dealing of politics, at a time when politics was possibly even more venal than it is today. Some people (myself included) find that kind of thing intrinsically interesting. This movie manages to entertain a broader audience because it has colourful characters and a story-line in which the goodies have to win in the end. In my view, the story is inspiring because it shows that fallible leaders can sometimes use democratic political processes to overcome entrenched interests for worthwhile purposes.

Given the history of slave ownership in the US it is not surprising that many politicians would have seen powerful reasons to keep deferring abolition, even while claiming to be opposed to slavery. While slave ownership remained profitable, slave owners had an interest in seeking to retain what they would have seen as property that they had acquired legally. Against that background, it seems amazing that sufficient numbers of representatives were eventually persuaded to take advantage of the opportunity to abolish slavery before the end of the civil war. (I still find it hard to accept that the civil war was necessary, but that is another story.)

I was intrigued by the part of the movie in which Thaddeus Stevens (played by Tommy Lee Jones) tempered his remarks in congress to avoid frightening conservatives that abolition of slavery would be a slippery slope leading to full equality. He refused to be goaded by an interjector to support the view that 'all men are created equal', rather than supporting 'equality before the law' even though he was a lifelong advocate of full citizenship rights:

'How can I hold that all men are created equal, when before me stands stinking the moral carcase of the gentleman from Ohio, proof that some men are inferior, endowed by their Maker with dim wits impermeable to reason with cold pallid slime in their veins instead of red hot blood! …

After further castigating the interjector, the passage ends:

' … even worthless unworthy you ought to be treated equally before the law.'

Those looking for further discussion of the movie should read, among other things, Jim Emerson's article, 'It's true because it works'.

I haven't managed to get far at this stage in learning more about human trafficking and debt bondage. Human trafficking has been defined to include a range of nasty activities - some worse than others in my view.

The UN's 'Protocol to Prevent, Suppress and Punish Trafficking in Persons' defines human trafficking as: 

'the recruitment, transportation, transfer, harbouring or receipt of persons, by means of the threat or use of force or other forms of coercion, of abduction, of fraud, of deception, of the abuse of power or of a position of vulnerability or of the giving or receiving of payments or benefits to achieve the consent of a person having control over another person, for the purpose of exploitation'. 

The US State Department's Trafficking in Persons Report (2012) suggests that trafficking doesn't necessarily require movement of people:

'People may be considered traficking victims regardless of whether they were born into a state of servitude, were transported to the exploitative situation, previously consented to work for a traficker, or participated in a crime as a direct result of being traficked. At the heart of this phenomenon is the trafickers’ goal of exploiting and enslaving their victims and the myriad coercive and deceptive practices they use to do so'.

The State Department also uses the ILO's term 'forced labour' to describe human trafficking. The ILO's estimate of the number of people engaged in forced labour throughout the world is 20.9 million – not much less than the population of Australia. Most forced labour apparently takes place in Asia, although prevalence as a percentage of population is higher in former communist countries of eastern Europe and Africa.

It is fairly easy for people in countries like Australia to claim that that human trafficking is a minor problem as far as we are concerned - and largely beyond our influence. However, people associated with the abolitionist movement in Britain in the 19^th century – people such as John Bright who was also a prominent advocate of free trade – did not take that view with respect to slavery in America.

When Lincoln was assassinated he apparently had in his pocket a testimonial from John Bright calling for him to be re-elected.