5.1 What are the Alternatives?
Before embarking on our discussion of our design for an EDGS, it’s worthwhile considering alternative of deposit guarantees. McCoy, P.A. (2007) highlighted six alternatives for governments to choose from: 1) enact law denying deposit insurance, 2) denying deposit insurance but provide deposits priority of claims on the insolvent bank’s assets, 3) maintain ambiguity in coverage commitments, 4) giving the impression of an implicit deposit guarantee by intervening in the banking market when these is a failure, 5) legislate for an explicit deposit guarantee with coverage limits, 6) expand the explicit deposit guarantee coverage limit to maximum during financial crisis and scale down to original limits when crisis recede.
In Table 1 below, we subject the alternatives to three qualitative impact areas: efficiency, equity and feasibility, deemed important in determining appropriate alternative. Efficiency relates to how financial institutions are affected by the various alternatives from the prospective of regulation and compliance cost and deposit insurance cost, that if excessive would affect their delivery of cost effective service. In the case of equity or fairness, moral hazard is our main consideration for each of the alternatives, while feasibility highlight the complexity in administration of each of the alternatives.
Using Table 1 as reference, our analysis of NZ’s alternatives would be restrictive, as our analysis is premised on NZ’s current position with an outstanding “blanket” guarantee and assuming that blanket guarantees cannot exist indefinitely. In this regard, we are analyzing the alternatives from an “exit” strategy perspective. The alternatives are clear, once we deduce our alternatives by eliminate the ones that probably will not work. The alternatives that will not work are the Governance Incentives and the Implicit Guarantee. The primary reason as to why Governance Incentives is eliminated because it is cumbersome to implement and will never work in practice, most financial institutions shareholders are institutional in nature and will be prohibited to enter into any “double liability” arrangements. The Implicit Guarantee position is the default position once the blanket guarantee is removed and no alternatives selected. As described in table 1, the moral hazard problem be elevated substantially as depositors will expect from the government nothing less than the limits in previous “blanket” guarantees. Therefore, leaving three remaining alternatives to choose from.
The No Guarantee alternative is the most appealing position for NZ to revert to, being that it feasible and all the requirements are fulfilled. However, the government would need to reinforce its stance and communicate clearly to the market, that no guarantee or bailout is to be expected. However, there are doubts that this alternative choice can work well in practice, given that a blanket guarantee was issued in the past and are at odds with practices in most other countries with some form of deposit guarantee in place. The other alternative is a Depositor Preference which would require retrospective review of the law and amendments, these can be time consuming and would create major upheaval from all financial institutions. Lastly, the Explicit Guarantee Alternative which would be the least cumbersome to adopt as most of the main design features are part of the “blanket” guarantee. The Explicit Guarantee have very little impact on efficiency or feasibility as we will be retaining most of the regulation but design feature would need to be rework to reflect current and future needs of the guarantee. In this regard, the Explicit Guarantee alternatives, may be the more appropriate alternative compared to the other two, although we cannot eliminate moral hazard problems but with the right design, moral hazard problem inherent in Explicit Guarantee can be controlled and effectively managed.
5.2 Proposed Design for An Explicit Deposit Guarantee Scheme (“EDGS”)
Demirguc-Kant, A. et. al. (2006:22) proposed six design principles that should be considered in implementing an explicit deposit guarantee. Firstly, the setting of enforceable coverage limits and that private monitoring of the scheme should be followed by official supervision. Secondly, membership must be compulsory to prevent adverse selection by large institutions to opt out of the scheme. Thirdly, establish joint private-public partnerships to oversee and manage the scheme. Fourthly, prevent shifting losses to taxpayers and any losses should be borne by the surviving members. The Fifth principle is appropriate pricing of the premium to commensurate with the risk and lastly, the members need to be involved in the insolvency resolution process to ensure prompt settlements.
Table 2 below describes our proposed EDGS based on the design principle framework based on best practices adopted internationally. (Please note all figures in our Proposed EDGS are only arbitrary in nature.) We have incorporated a column for comments on design options, to explain the rationale for our proposed EDGS. Nevertheless, the rationales would require further independent studies, Benefit -Cost Analysis and other computations, in order to derive an accurate specification for each component of the design framework.
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